Who Made Money Yesterday During the Dow's Swan Dive? Smart Futures Traders - UPDATED

Ivy Schmerken published a nice overview piece on yesterday's market dislocation on the Wall Street & Technology Blog. A little background for those who have not been following the discussion:

As most of us know, problems began around 2 p.m. when the Dow Jones Industrial Average was already down 200 points –- in part a reaction to the sell-off in Chinese stocks, translated into concerns about the U.S. economy. I was in the car at 2:30 p.m. when CBS Radio reported that the market was crashing and the Dow was down 250 points.

The heavy sell-off in U.S. stocks caused a 70-minute lag in correctly calculating the value of the Dow Jones Industrial Average, according to Dow Jones Indexes, which issued a statement today.

In the release, Michael Petronella, president of Dow Jones Indexes, said the problem arose in the system responsible for feeding market data into the calculation system.

Recognizing the problem, Dow Jones Indexes switched to a back-up market data system for calculating the index, which immediately caused the index to drop by another 200 points at around 3 p.m. -– so the market was down over 500 points.

The switch over to the back-up systems caused all the prices to be processed at once, and this led to the downward spike in the reported index value, according to the release. When the Dow Jones index was adjusted to the true value and the market plummeted 200 points, this probably triggered algorithmic trading programs to generate buy and sell orders, which were concentrated in the Dow 30 stocks, rather than dispersed throughout the market, the source conjectures.

Ok, this makes sense. I don't know, maybe it makes you think that that Grasso guy wasn't so bad after all, but no matter. Bottom line - we had a little meltdown, the cash market systems couldn't keep up with the order flow and, therefore, the DJIA gapped down hard after the flood gates were opened. But what happened in between? Was there anyone, anywhere that could have made money from this debacle?

Of course. The answer: smart futures traders.

Please take a look at the chart below.

See the black line - that's the spot DJIA. See the blue line - that's the March DJH07 futures contract traded on the CBOT. So, let's walk through this together. In the morning the spot and futures markets pretty much tracked each other. Then look what happened - uh oh, the spot market is falling behind, while the futures market is reflecting the true market sentiment. They are starting to diverge, then wider, wider still, FOR ABOUT TWO HOURS, until BANG - the alternative cash system kicks in and the flood of sell orders drops the spot index like a stone. So this technical "glitch" was really, at its core, a timing delay. Then the futures market, as if it knew what was going to happen, ran up, after which the spot market followed with a significant lag. After a little sputtering and some continued dislocation late in the day yesterday, they tracking each other once again today. Whew.

So what does this mean? A savvy futures trader that saw the divergence could have positioned themselves to profit from the inevitable meltdown in the spot market, and the subsequent run-up after the futures rallied ahead of the spot market. AND HAD ABOUT TWO HOURS TO DO IT. It is pretty rare to find these profit opportunities in the real world, but they manifest themselves yesterday during the wild ride in the U.S. afternoon trading session.

Anyway, I generally don't write much about this stuff but felt compelled to share this after knocking around some thoughts with a couple of my colleagues. Interesting day, to be sure. Thanks to Eli for this thoughtful contributions and the chart. Enjoy.

ADDENDUM

In the wake of comments received by readers of this blog, I was made aware that there is an error in my chart - the plotting of the CBOT futures contract is not adjusted to take into account the NY/CHI time difference. First, thanks to those who commented. This is exactly what makes the blogosphere great. I'm usually the one imparting the checks-and-balances, but today I am the recipient of such!

All that said, I'd like to factually explain why the error occurred, and then to migrate to why I believe an arbitrage opportunity did exist, even after correcting for the time mistake. The only substantive difference in the analysis is that instead of a trader manually being able to enjoy the arbitrage profits that were available, the money was invariably captured by stat arbs whose programs picked up on the difference between the the spot DJIA (or the DJIA components individually or in ETF form via DIA) and the theotretical DJIA (as expressed through the CBOT futures). And I respectfully disagree with both Maoxian and my two commenters that arbitrage opportunities didn't exist, because they clearly did. My charting mea culpa and evidence of the availability of arbitrage profits follow.

Why the Error?

The chart from my post was taken from OptionsXpress, which uses Prophet.net for their charting application. Apparently, when comparing two instruments, Prophet.net does not adjust for time discrepancies, which means that clearly OptionsXpress doesn't, either.

From Prophet.net

From OptionsXpress

It also appears to be the case that Yahoo!'s new Beta charting application may also give rise to the same error:

   

These errors, not surprisingly, are not present when one undertakes the same charting exercise on Bloomberg:

So, for those who expect (as you should) factual correctness in all that I write I apologize. I am both embarrassed and humbled by this error. I'll work hard to ensure that it doesn't happen again.

The Argument for the Availability of Arbitrage Profits

Let me start with presenting a more granular decomposition of the Bloomberg data above, by importing the data into Excel and plotting the price movements in five minute time increments:

Ok, so do you see the divergence between the spot and the futures? It is not two hours, as I had mentioned orginally, but the divergence is in place for around an hour (which makes sense given the NY/CHI time difference). I'd like to use Chairman Mao's post as a vehicle for arguing my point that arbitrage profits did in fact exist:

Everyone knows about the Dow Jones Industrial Average calculation glitch during Tuesday’s slide. Here are a couple overlay charts: 1) the Dow futures with the DJIA, and 2) the Diamonds ETF with the DJIA. You can see that both the futures and the ETF were tracking the Dow component stocks correctly the whole time. There were no opportunities for arbitrage.

Well, I don't really agree. He is using candlestick charts, which are not sufficiently granular to observe the arbitrage opportunity in question. So no, you can't  "see that both the futures and the ETF were tracking the Dow component stocks correctly the whole time." Because they weren't and I think that point is pretty widely acknowledged. He continues on to say:

I don’t even watch indexes on a quote sheet anymore (who watches the DJIA intraday anyway?), but I do follow all the ETFs based on major indexes closely. I can trade the DIA; I can’t trade the DJIA.

Ah, this is the point. I find the chart comparing the DIA and the DJIA to be a red herring. One is simply the decomposition of the other. They should track each other, by definition. This is not the case with futures and cash, where divergences occur for a wide range of reasons, including technical glitches. But the comment that was the most telling: "I can trade the DIA; I can’t trade the DJIA." You may not be able to, Chairman, but stat arbs can and do, often thousands of times a day. How could a stat arb have made money? By their programs detecting the divergence between DJIA "real" (the average of the prints of the components that make up the DJIA) and the DJIA "theoretical" (the CBOT futures), executing program sells of DJIA-replicated single-stock baskets across any number of ECNs and simultaneous buys of the futures. While the stock trades wouldn't have printed due to the glitch, they would have been filled and settled after the backlog had been cleared in the 2:50-3:00PM time frame. Therefore, a stat arb who had sold the cash "rich" and bought the futures "cheap" could have captured the area between the two curves, ex-transactions costs. Not a bad return for a few CPUs.

I've read a lot of pretty virulent talk about how arbitrage conditions didn't exist. My charting error notwithstanding, I don't agree. And I think the facts - real as they are - are pretty compelling. But that is just my two cents. I'll leave it to the experts (those who write this stuff and pull down charts every day) to tell me otherwise.

The Wallstrip Blackberry Shoot-Out (RIMM): Total Humiliation!

Some of you may have seen the intense Blackberry Competition show immortalized on Wallstrip today. It was myself, Fred Wilson (Union Square Ventures/NY), Bijan Sabet (Spark Capital/Boston) and Howard (from Phoenix by way of Canada and possibly Mars), thumbs a thumbs in a type-and-scroll to the death. Suffice it to say, I was schooled. I let down all those people who have sent me emails over the years that I responded to within nanoseconds via my "thumbs of lightining," and provided the training that I felt would serve me well in the heat of battle. Unfortunately, and clearly visible on the show, I was having a bad hair day. I hadn't stretched properly. I was too tight. Almost as bad as Howard's "phantom pinkie" issue.

So the ringer from Boston swoops in and takes the crown. I have to say Bijan clearly outclassed the three of us. He has thrown down the gauntlet for a rematch. All I know is that I need to work hard on my rapid scrolling. I know a bunch of you cocky Blackberry users are saying "Hey, I could kick those guy's a**es." Let me tell you, try this test. Take four painfully long sentences with capitals, punctuation, etc., send yourself an email, and reply to that email. While being timed. Where mistakes count. And you're being heckled (or whistled at, as I did to Howard with my rendition of O Canada). It's not the typing, smart guy. It's the scrolling that's hard. Back and forth and back and forth. Speed typing is another type of contest - this was the Blackberry Olympics: all scrolling, all the time. Try it. It's f&cking hard.

Thanks to Wallstrip and Bijan for taking me down a few pegs. I certainly won't be talking smack about my Blackberry exploits - until next time.

SIRI/XMSR Revisited: An Advertising-driven Google in the Sky?

Overview

Most of what's been written about the SIRI/XMSR merger has put forth a vision of the future focused on two value drivers: (1) cost savings; and (2) sheer necessity, given the weakened financial state of both companies. Based upon my analysis of Internet data, I posited that while the magnitude of the potential cost savings couldn't be denied, the opportunity for advertising revenues was substantial and largely discounted by the market:

Analysts are expecting Sirius 2006 revenues of approximately $615 million on about 6 million subs (up from 3 million prior to Howard's joining). Similar to the simple-headed but somewhat effective method I used when justifying Google's purchase of YouTube on a valuation basis, I will seek to bring some back-of-the-envelope intuition to the potential for Sirius' ad revenues.

2 channels x 24 hrs/day = 48 hrs of programming/day
x 3 ad minutes/programming hour = 144 ad minutes/day
x 200 broadcast days/year = 28,800 ad minutes/year
x $5000-$10,000/ad minute = $144-$288 million ad revenue/year

Wow. Is this possible? Haircut these numbers by 50% and it still looks like Howard has the potential to cover his basic $100 million nut based upon ad revenues alone. Add in the value attributable to those incremental subscribers (3 million x $120/year = $360 million) and Mr. Clayton's pie-in-the-sky deal doesn't look so crazy after all. Further, it appears that Howard's Sirius' ad revenue numbers could eventually eclipse those from his Infinity days.

Further, there are some very interesting discussions concerning the technology issues embedded in the merger, i.e., whether SIRI and XMSR users have the ability to get both signals through their existing receivers, the ramifications of large numbers of terrestrial repeaters within key markets across the U.S., etc. These issues, while important, have certainly not been in the forefront (or even holding up the rear) of discussion in the wake of the merger announcement.

After collecting some additional data and attempting to connect the threads running across several important themes, I'd like to put forth an even bolder vision of the merged entity:

A subscription-based provider of premium digital content, with the ability to deliver targeted, relevant advertising through the airwaves as Google does over the Internet.

I know, this is a pretty bold vision of the future for SIRI/XMSR. Let me first validate the thinking around advertising as a key value driver of the merger, and then proceed to the somewhat more out-of-the-box thinking relating to targeted advertising through the airwaves. I've got to think that a big-picture, swing-for-the-fences, deal-making and advertising-savvy guy like Mel Karmazin has to be thinking about this stuff; he's just keeping it to himself in order to shock the world. But not me.

Advertising and The Merger

Howard and Mel had a little chat about the merger at 7:30am this morning. Two big guys, two big personalities. Good stuff. Mel raised a lot of interesting points during the discussion, which you should definitely check out, but the key point related to advertising and governance is here (from MarksFrigging.com):

Mel said that each of the companies have advertising and it will be a good thing when they can go to advertisers and tell them that they have over 13 million subscribers to advertise to. Howard asked Mel where they were holding these meetings and stuff. Mel said he had them over to his apartment and that's where they would go over all of this stuff. He said that things didn't work out for a very long time because there were arguments over who was going to get 55 percent of the company and who was going to get 45 percent. Mel said that XM was arguing that they had more subscribers and more deals with car companies. Mel said SIRIUS argued that they had better content and were growing faster. Mel said that at the end of the day it was a 50/50 deal. Mel will be the CEO of the company and Mel said that both boards agreed on that whole thing. He said he would have been happy to step aside if that wasn't acceptable to them.

13 million and rising fast - that's a pretty serious user base off which to work. It's also interesting to note that a little visit to the SIRI website turns up seven recent job specs for Account Managers selling radio advertising. Mel knows that while the subscriptions are nice, advertising is the big embedded call option an investor is getting in the merger, an option which he fully intends to monetize for the benefit of SIRI/XMSR shareholders - including himself.

Another point I'll make before getting into the technology discussion is that each satellite receiver has its own unique digital ID. So what? Well, presumably that unique ID is attached to a person or people that have preferences - preferences which can be gleaned by usage (i.e., this ID listens to these shows at those times and in these locations) or by selection (i.e., checking off interests on a secure website which then facilitates targeted advertising based upon user profiling). All I'm saying is that this is an interesting factoid that warrants a little consideration - and expansive thinking.

Advertising and Technology

Terrestrial repeaters. Huh? A little background, from CED Magazine 12/01/2006:

In 1997, XM Radio and Sirius each won satellite radio broadcasting licenses in an FCC auction, each paying around $85 million. The FCC called the service Satellite Digital Audio Radio Service (SDARS). From the start, SDARS was expected to need a network of terrestrial repeaters to fill in shadowed areas.

This was flagged as a "hot button" issue between the satellite radio companies and the terrestrial radio companies (as represented by the National Association of Broadcasters - or "NAB") several years ago. From audio/video revolution 06/30/2004:

Both satellite players use terrestrial repeaters (similar to cell phone towers) in major cities to bolster reception of their signals. A spokesperson for Sirius tells AudioRevolution.com that Sirius has terrestrial repeaters positioned on top of buildings, including the McGraw Hill building in Manhattan and on top of a medical building near the 405 freeway in West Los Angeles. In the case of Sirius, these repeaters reach five to 10 miles in range and help broadcast Sirius’ signal into the hard-to-reach canyons of Los Angeles, as well as into the cement super-structures in New York.

Some repeaters have the potential of more power – a lot more power. Several years ago, reports from Inside Radio, a leading radio industry trade publication, said that some of XM’s terrestrial broadcast capabilities in cities like Boston are as much as 50,000 watts, meaning they could compete with the strongest FM stations and have exponentially more power than a smaller repeater. Thus the concern that has the radio industry up in arms. Under this scenario, the satellite providers are just an FCC ruling away from being competition for the local ad dollar. This would be catastrophic for terrestrial radio, which depends largely on local, not national, revenue to make its profit.

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No less than the radio trade organization NAB was an early accuser of satellite radio’s intentions. Powerful chairman Edward O. Fritts came right out and said it – satellite radio wants to get into the local radio business. While XM and Sirius denied it, there is a general feeling among radio broadcasters that they would not be surprised to see their satellite competitors try to win regulatory changes that would allow such competition.

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What traditional radio does best in the world of advertising is reach customers locally and regionally. The satellite providers are starting to legally provide traffic for major cities, which possibly points towards their interest in providing more local content for their users. The traffic move could also simply be a way to keep their new and existing subscribers from having to flip-flop back to terrestrial radio to get critical traffic information. This is not dissimilar to TV satellite operators. When satellite television was able to provide local channels, new subscribers signed up by the millions. The satellite music companies would likely to see the same kind of bump. They also could sneak in local ads that could potentially generate hundreds of millions of dollars of revenue.

So you get the point. But what of this move to potentially attack the local advertising markets? Back for just a moment to our friends at CED:

Those poor folks at Sirius and XM Radio. They just get finished with one FCC scandal–overpowered FM modulators that violate FCC Rules–when they have to disclose that their networks of terrestrial repeaters have been operating illegally. As it turns out, those violations are no big deal. But as I began to investigate this latest controversy, it suddenly hit me. They aren't really satellite broadcasters with terrestrial repeaters to fill in the coverage gaps. What they really are is terrestrial broadcasters with satellites to fill in the coverage gaps.

You can hear the terrestrial radio broadcasters right now shouting "Danger, Danger, Danger..." Now if you really want to adopt a "conspiracy theory" mind-set (e.g., the satellite broadcasters knew all along that this was the endgame, regardless of what they've said in the past to the FCC and the NAB), check out this link showing the Sirius control room. See that screen in the upper left? Those are the locations of its terrestrial repeaters. Notice the bunching in those heavily populated, super-valuable advertising markets? They've got local broadcast capabilities even through they're a "satellite radio company." Ha! And the punch line from CED:

From a spectrum policy perspective, there should not have been any need for XM and Sirius to register the locations of their repeaters with the FCC. They both have exclusive nationwide licenses for their frequencies. If they cause co-channel interference, it would be only to themselves. If the FCC gets around to adopting rules for these repeaters, the rules will undoubtedly say that repeaters can be deployed anywhere, so long as they meet the as-yet-undetermined technical rules. But under the FCC's temporary authorization rules, every transmitter must be registered. So this "scandal" is much ado about nothing.

On the other hand, this controversy has revealed that XM Radio and Sirius have cleverly transmuted their satellite licenses into terrestrial broadcasting licenses. Sure, the NAB is unhappy. But there are millions of listeners who love it...and most of them don't even listen to Howard Stern.

The whole point of this line of discussion is to make the following argument: the real upside in the SIRI/XMSR deal is the advertising, not the subscription revenue. I think some of the biggest questions are:

1. How quickly can an integrated advertising strategy be developed?
2. How quickly can SIRI/XMSR users get access to both signals across a single device?
3. How quickly can ad rates reflect the combined subscriber base versus each in isolation?
4. How quickly can metadata be captured, collected and monetized based upon listener behavior and preferences, akin to cookies and/or memory of historic activity?

Getting the answers to these questions is, without question, worth billions in equity market value to the combined entity.

There has been a lot of discussion around the ability of the existing satellite receivers to pick up different signals, i.e., of SIRI and XMSR. The SIRIUS Backstage blog had a pretty comprehensive discussion of this very issue on 02/21/2007 in a post titled "Can Sirius and XM Radios Pick Up Both signals today?"

While there is no concrete answer, we have found a couple pieces of evidence that Sirius and XM may be able to keep the current radios of today and still offer all of their content to both sides. First, at Select Satellite Radio, the group that is in charge of making a dual-radio in order to ensure the FCC stipulation that they develop one, states this:

“It is acknowledged that SIRIUS, XM and their manufacturing partners already produce receivers that permit end users to access all Satellite Digital Audio Radio systems in compliance with FCC interoperability obligations.”

It appears that this implies radios today can receive the entire satellite digital audio radio services(SDARS, the technical term for satellite radio) spectrum.

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Furthermore, for the first 6 months or so, XM used the same codec that Sirius does, Perceptual Audio Coder(PAC), before they switched over to AACplus in April, 2002.

So, right now we have two questions that need to be answered:

1) Do XM’s newer radios still decode PAC?

2) If so, does it mesh with the evolved version of PAC that Sirius uses?

If the answer to both is yes, then it looks like there is a strong chance radios will be able to pick up both services down the road. This of course assumes that the merged company broadcasts solely in the PAC codec.

Ok, sounds pretty good, right? But in the comments to the post, there are some amazingly detailed and educated perspectives on precisely this issue, with the conclusion being that the existing receivers are not sufficient to pull down both signals. Check out comment #18:

I'm an engineer, so I know a bit about how the radios work. Without getting too technical, the best likely case is that an existing Sirius or XM radio might be capable of receiving both sets of signals, but they'd always be handled as two different sets of channels with a "hard" mode switch between them (kind of like "AM" vs "FM"). In other words, you could switch your radio from "Sirius" mode to "XM" mode, but it would take a few seconds (maybe 20-50 seconds or more) before it locked on to the new mode's signal and authenticated itself.

That's the best case. I'm not saying it's definitely possible, just that even under the most ideal circumstances, the best anyone with an existing radio can hope for is to be able to reflash their radio and switch it back and forth between "Sirius" and "XM" modes.

OK, I lied. I'm going to get techincal anyway. Here's the hardcore explanation:

Sirius radios don't tune channels. They tune 3 bitstreams -- two from the satellites above, one from the nearest terrestrial repeater. The signals are combined together to produce a single encrypted bitstream that carries all of the audio channels and meta information about them. This encrypted bitstream gets passed along to the baseband chip.

The baseband chip checks its records to see whether it's been authorized to decrypt the bitstream. If it hasn't, or it's about to need a refresh, it decrypts and examines the first chunk of the encrypted bitstream's datagram for the subscriber ID burned into the chip at the factory. If it sees its number, it notes the authorization. Otherwise, it waits for the next datagram and does nothing further with the current one.

Once authorized, the baseband chip deserializes the bitstream into the various channel streams. The desired stream then gets buffered and fed to the codec, which transforms it into an uncompressed PCM datastream. That datastream passes through a low-end DSP, and finally gets fed to a digital amp, which is basically a high-power DAC whose output needs no further amplification. Alternatively, it outputs it to the FM transmitter for PnP use.

Anyway, the point I'm trying to make is that the chips involved are fast enough to process Sirius' bitstream in one gulp, but NOT fast enough or equipped with sufficiently-large buffers to take in a bitstream twice as large (encompassing Sirius and XM's content) in a single operation. They're pretty fast chips to begin with, and value-engineering will ultimately result in chips that are just barely fast enough to do the task they're designed for, but nothing more.

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by miamicanes             

So maybe a quick fix to this receiver issue isn't in the cards. No matter. The potential value we're talking about far dwarfs the costs associated with either a retrofit or a receiver replacement program. Why? It's all about the data.

Google in the Sky

When the services are integrated, you'll have a broader array of programming available than if you were a subscriber to only one. This may encourage more people to enjoy the benefits of high-quality, crackle-free, proprietary content available from the merged entity. And even before more subscribers join, SIRI/XMSR will have 13 million+ legacy subscribers from which to entice advertisers. This is real power. But wait; remember that stuff we were talking about concerning the ability to deliver targeted ads locally (terrestrial repeaters dotting the densely populated, high-value landscape)? And remember the unique ID that each receiver has? And you know how SIRI and XMSR "push" information to subscribers, whether it is the name of a song, an artist, a sports score, the url of an advertiser (in the case of SIRI), whatever? What if they started to "pull" information concerning station choice, location, time of day receiver is active, length of time receiver is active, maybe user-provided preferences concerning various interests (restaurants, concerts, merchandise, etc.)? What's to stop them from delivering tailored advertisements and content recommendations to you, a la Google and contextual advertising? All the pieces are there. It is simply a matter of putting it all together.

Does this sound crazy? It doesn't to me. Now there is the small matter of the Justice Department and the FCC letting the merger happen, which is kind of the precursor to this whole line of discussion. But assuming the merger does go through, and SIRI/XMSR captures the benefits of the combined cost savings together with a larger and more attractive subscriber base, it will have the resources necessary to access, analyze and monetize the user-generated metadata to turbocharge their advertising machine. And this could represent a new paradigm for how value is extracted from the airwaves. Kind of like how Google showed us how to extract value from the Internet.

Am I dreaming? Maybe. But sometimes dreams come true.

A Foundation for Innovation

Robert Litan had a short, hard-hitting, pragmatic editorial in yesterday's WSJ titled "Innovators Matter Most." There is a lot of high-level talk about what fosters innovation in a society, but Mr. Litan does a particularly good job laying out the issues in plain english that should make us wake up and take notice. As someone who has built and run high-performance teams on Wall Street and in start-up environments, I can really appreciate the points made in the editorial and know the prescriptives mentioned to be right and true.

While many elements of Litan's piece specifically relate to the issues raised by Thomas Friedman in his book The World is Flat, one is able to get much of Friedman's essence in a 500-world editorial. Is it certainly worth a quick read. The editorial's issues and recommendations are pulled from a survey co-sponsored by the Kauffman Foundation and Inc. Magazine:

Recently, the Kauffman Foundation, with the assistance of Inc. magazine, asked some of the nation's most successful entrepreneurs what they needed to grow. They cited four challenges, and academic research has helped to pinpoint the policies that best respond to each of them.

Ensuring a skilled work force. Entrepreneurs say that the biggest constraint on growth is finding "talent" -- highly skilled, entrepreneurial workers. Thus we will need major improvements in K-12 education, which are unlikely to come about without more charter schools: parents and students being able to choose their schools, and principals and teachers with more freedom, and accountability.

We also can use as many skilled immigrants as are willing to come here. Recent surveys indicate that immigrants have been essential in forming a quarter of our rapidly growing high-tech companies. We ought to be encouraging, not limiting, the entry of such people. How about giving permanent residency to any foreign student who obtains a math or science degree at one of our universities -- since these skills are key to the formation and growth of high-growth companies of the future?

Reforming health care. Escalating health-care costs rank high on entrepreneurs' lists of concerns. They're not alone. Workers are anxious about losing their own health insurance, especially if they take the risk to leave their stable jobs to form their own businesses.

The obvious answer to both challenges: Phase out current tax linking employment with health care, using the revenue to subsidize the purchase of health insurance by those of limited means. President Bush has offered one approach, surely there are others. Whatever is done, prohibit insurers from discriminating or refusing to insure based on an individual's pre-existing health conditions (as we do for genetic conditions).

Promoting innovation. We already do a great job innovating and commercializing. But we can do better, by enhancing government funding of research in basic science and engineering; reforming patent law so that protections are not so overly broad that they inhibit the creation of innovative, new firms; improving ways for university-developed ideas to be commercialized; and funding efforts to identify and take advantage of innovations developed abroad, just as foreign companies have been doing with U.S.-based innovations for decades.

Limiting costly regulation and liability litigation. Because of their small size, entrepreneurial firms are especially vulnerable to excessive regulation and liability litigation. Accordingly, entrepreneurs have the most to gain from sensible reforms requiring all major federal (and state) regulations to be implemented only if estimated benefits exceed costs, and by adopting further liability law reforms (without reducing incentives for all companies to make safe products). Two reforms would help curb frivolous litigation: adopting the "English rule" -- loser pays -- on attorneys' fees for litigation with commercial parties on both sides; and limiting the award of punitive damages where defendants have complied with prevailing regulatory standards.

Amen. While the issue of creating the optimal environment for innovation is multi-faceted and complex, I think the four issues raised here address at least 90% of the problem. Ane while I was not specifically surveyed on these issues, I think I may well have answered exactly the same way. Mr. Litan finishes his piece with the following thought:

These proposals are quite different from the ones policy makers in Washington and elsewhere traditionally discuss when trying to promote entrepreneurship -- such as increasing the budget of the Small Business Administration, or reserving a certain percentage of federal contracts for small business. Entrepreneurship Week USA begins this weekend. What better time to begin a serious debate on these larger issues so vital to our economic future?

What better time, indeed. Given the increasingly global market for talent, well-heeled and upwardly mobile competitors like China and India, rising standards of living across much of the world and relative complacency among Western nations, these are issues that require attention from every branch of U.S. Government - now. Time is a wasting. Hopefully we won't be by ignoring a problem when in possession of solutions for a new, brighter and increasingly innovative future.

Three from the NYT: On Strategy, Culture and Boredom

It has been quite some time since I've published a "3 from the NYT" piece - but the time has come.

1. Andrew Ross Sorkin on "When Unequals Try to Merge as Equals" - the Sirius/XM merger

My punch line: Mel Karmazin is a smart, logical guy focused on the big picture, for the benefit of Sirius shareholders. And Mr. Sorkin's questions concerning the economics and timing of the merger announcement miss the boat from my perspective, only serving to reinforce a myopic and cynical view that obscures the big picture: that this merger is both necessary and value-creating for both Sirius and XM shareholders, especially in light of questions over the long-term viability of satellite radio as a value-added distribution platform. The merger at least gives these two companies a fighting chance to find out, and in the most efficient and shareholder-friendly manner possible.

Andrew's lead, to set the stage:

HERE’S a tip about deal-making: When companies start talking about a “merger of equals,” someone is usually getting the better deal. It is especially true in the proposed merger of XM Satellite Radio and Sirius Satellite Radio.

It is being billed as a merger of equals, with each company getting exactly half of the new entity.

But here’s the unequal part: The stock market thinks that Sirius is worth almost $1 billion more than XM. To get the numbers to work, Sirius offered to pay a handsome 22 percent premium to shareholders of XM. (The premium is actually almost a whopping 30 percent if you account for the run-up in XM’s shares the Friday before the deal was announced, as word began to leak.)

And then, a little more color to make the point:

And then Mr. Parsons played his ace: If Mr. Karmazin wanted to create the enormous savings they both projected would result from a deal — worth more than $5 billion, more than the value of either company — they needed each other.

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“I can’t do the deal without them,’ he said. “I thought it was more important for our shareholders that we do the deal.”

Even by giving the 22 percent premium, Sirius stands to save billions of dollars a year if the deal goes through.

These are facts. And the fact is that Mel is a big picture guy, and Mel wants to run a successful and viable entity. Is paying a premium for XM when the deal is billed as a "merger of equals" either irrational or untrue? I don't think so. Both hold valuable and necessary keys to unlock the value of the combined enterprise. I think it is quite clear what is going on here and I'm not sure why this point warrants much discussion. The cost savings alone, even if one assumes savings on the low end of the projected range, are worth well north of $10 billion. So 22% on XM's stock price to get the deal done and to get busy? A small price to pay.

The Andrew goes on to discuss the other possible motive for "rushing" into things now instead of waiting until their stock price somehow magically align in order for a "true" merger-of-equals to organically take place:

Still, it seems as if Mr. Karmazin may be paying a premium to do the deal now so that it can be rushed through the regulatory maze while the Bush administration is still in power. Many partners in mergers of equals wait around — often for years — until their stocks align.

Mr. Karmazin disputes that view, contending that he wants a deal as soon as possible so that the savings can start. His view is that there “is no regulatory window.”

In fact, he believes that the longer the companies, both now money losers, wait to merge, the better their chances would be in Washington. That’s because new technologies will continue to emerge that may prove to be competitive with satellite radio.

So Andrew puts forth the "ulterior motive" theory, and I've got to say Mel gives the right answer. Besides which, Sirius and XM have been tap dancing together for quite some time; it's not as if this is a shotgun marriage. Much thought, analysis, pondering and negotiating went into last week's announcement, so I find Mr. Sorkin's line of argument more consistent with conspiracy theory than one grounded in fact or logic. Regardless of Administration, this is going to be a challenging merger to get through the Justice Department (not that it should, but it will). But those cost savings are real - and pressing - and they are both spending prodigious sums to win in the marketplace, dollars that could be spent together in a more efficient manner developing better consolidated programming and reaching its target audience.

So Mr. Sorkin, I don't think it requires much thinking to answer the "why, when and how" this merger got announced - and it is far more simple and logical than you are making it. It is driven by the need to extract value - now. To stop the bleeding. And I hope Mel is able to get this deal done - and fast.

2. Leslie Wayne on "Starbucks Chairman Fears Tradition is Fading"

My punch line: Howard Schultz, Chairman of Starbucks, is the one guy that can help bring it back to its roots, even in the face of pressure to continue its global expansion drive. And he has the passion, vision and credibility necessary to do the job. I wrote about some worrying signs at Starbucks some months back, in a 11/26/2006 post about a little coffee shop in my Greenwich Village neighborhood called Joe. I cited five reasons why Joe was successful in a crowded field with much larger, more powerful competitors:

1. Unbridled Confidence
2. Obsessive Attention to Detail
3. In Touch with the Market
4. Condescending Competitors (read: Starbucks)
5. Ruthless Focus on Quality

I went on to conclude the following:

At this phase of Joe's existence Jonathan is right. Better to focus on refining and perfecting the model than expanding rapidly. Get the model right, learn how to scale and do so - deliberately. This will drive a stake into the heart of the marginal Starbucks, Cosi and other crappy-experience stores. Why would anyone in their right mind go to one of the mega-chains that have lost touch with their customers versus a place like Joe? Answer: they wouldn't.

This is classic Schumpeter creative destruction in action, admittedly on a micro-scale as we speak. I've written a lot about this and believe strongly that creative destruction is a healthy, and unavoidable, fixture of economic development and a natural part of the company life cycle. Success, without question, sows the seeds of failure, as rapid growth has diluted the Starbucks culture and experience and rendered them vulnerable to a down-home, grass roots entrant like Joe. Further, times change, value propositions shift, and the $5 for a consistent venti skim latte just doesn't exist any more. Yeah, people are now spending $5 for this when they don't have many good alternatives, but what about when more Joe's (or places like them) spring up around town? Invariably, they will. I'll tell you one thing - I'd sooner spend my $5 at Joe or even at a Dean and Deluca than I would a Starbucks any day. Better preparation, better experience, and I feel better giving a smaller establishment my money than the Seattle behemoth.

Well, it seems as if my concerns were not without merit, given Mr. Schultz's recent note to Company executives:

The last thing that Starbucks wants is watered-down coffee.

It may not have that. But in a passionate internal memorandum to Starbucks executives, the company chairman said that a drive for efficiency has led to a “watering down of the Starbucks experience.”

Rapid expansion, the chairman, Howard Schultz, said, has led to a “commoditization of our brand” that makes the company more vulnerable to competitors. Specifically, he cited several decisions that, he said, may have been right at the time, but which, in retrospect, have led to a “dilution” of the coffeehouse experience that he wanted to foster.

The memorandum was sent on Feb. 14, and first appeared on the Web site starbucksgossip.com. It also reflects one issue that Mr. Schultz has identified over the years — the delicate balance between expanding into a global brand while maintaining the intimate communal experience that led to success.

A Starbucks spokeswoman, Valerie O’Neil, confirmed the memorandum and said yesterday that it reflected “that we are mindful of our responsibility to do better.”

Do Howard's concerns sound familiar? He clearly gets it; something I could casually observe in my own little world is something being perceived by him on a much broader scale. I give him tremendous credit by wanting to shake things up a little for the good of the brand, the Company and its shareholders. By the way, this Valerie O'Neil is the same one who said the following back in November when speaking about successful upstart coffeehouses like Joe:

Starbucks said it welcomed the competition. “There is room for many coffeehouses in the marketplace that can meet different customers’ needs,” said a spokeswoman, Valerie O’Neil.

I'll say now what I said then: that was a stupid thing to say. As a shareholder, do I want to hear this? No. I want my company to crush the competition. But the way to do this is by working to constantly improve the product and the experience and, in the case of Starbucks, to build and preserve the value of the brand that has been so carefully cultivated throughout its existence. This can't be done by implying "We're big, we're successful, let other competitors come in and chip away at our brand," which is effectively what has happened with a small shop like Joe, which started at one location and how has three. And I'm sure before long it will be five, then seven, then...

Good thing Howard is weighing in. He gets the issue of culture and brand, which is really what has made Starbucks one of the great American success stories of the past 20 years. Hopefully his words will fall upon open ears; otherwise, creative destruction may take hold sooner than you think.

3. Ben Stein on "Of Tax Cuts and Those $10 Million Bat Mitzvahs"

My punch line: Readers of this blog know that I respect Ben Stein and his intellect a great deal and, while not always agreeing with him feel that his heart is always in the right place. But this little rant in today's NYT appears to the culmination of years of frustration that we, the dopes reading the NYT, just don't seem to get it. Or he may just be getting bored with us and needed to write something for today's column. Ben's far-ranging complaints begin at crappy customer service, wind around to conspicuous consumption fueled by conservative tax policy,  make a visit to the ills of Management Buy-Outs and finish at the lack of competitiveness of the U.S. financial markets.

Clearly somebody spiked Ben's Wheaties this morning. Usually he is more focused in his criticism and irritation, but today he pretty much covered the landscape. Customer service? Sure, Ben, I feel your pain. Nothing pisses me off more than when I pay good money for an experience, a key component of which is service, and I am let down. Ok, this sucks. My advice to you: provide feedback; don't patronize that particular establishment; write a letter to HQ; sell the stock; offer your services as a consultant. I don't think this quite rates a Sunday column in the NYT.

Conspicuous consumption? If this consumption, which itself creates jobs and opportunity, is motivation to work hard and create value, which, in turn, generates rewards with which you can consicuously consume, then what is the big deal? Is your argument economics or utility? I can certainly appreaciate that your utility function may look different than someone who throws a $10 million Bat Mitzvah, but is that really your business? The spending associated with a $10 million Bat Mitzvah ripples through the economy, in a positive way. Further, the ability to spend $10 million on a party might itself be motivating to the party-thrower, who is incentivized to work hard to be able to throw more such soirees. This isn't a bad thing, Ben. The money is being pumped into the economy. Sorry if you don't like the way people spend their tax breaks. Those tax breaks are motivating and ultimately do lead people to invest in businesses, whether directly or through consumption that incentivizes others to invest in their businesses. 

MBOs? We've talked about that. Sure, there are problems with how they are handled. I'm with you there. But didn't you just write about this less than two months ago? Are you running out of good material? And, finally, the U.S. financial markets? You have a point, particularly as it relates to listing fees (and SarBox, I'd argue). But again, old news.

Love you, Ben. But please, make sure you are taking those Wheaties straight. Because this morning there clearly was a problem.

The Presidential Working Group on Hedge Funds Has Been Reading My Blog! Amen.

So the Presidential Working Group on Hedge Funds has spoken - "no" to new regulation, but a stepped-up focus on accredited investor standards, regulated institutions and fiduciaries. I've got to say that these are exactly the themes I've been writing about since August, and with greater frequency over the past few months. It's nice to see that my hiatus from Wall Street has not rendered me completely out-of-touch with my former vocation. I am obviously thrilled with their conclusions and recommendations, and believe they are supportive of continued innovation and the further development of the hedge fund business in the U.S.

Some snippets from today's New York Times article:

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Instead, the administration, in an agreement it reached with the independent regulatory agencies, announced that investors, hedge fund companies and their lenders could adequately take care of themselves by adhering to a set of nonbinding principles.

The principles, many already being followed by the sharpest investors and best-run companies, say that investors should not take risks they cannot tolerate and should carefully evaluate the strategies and management skills of hedge funds. They also call for funds to make clear and meaningful disclosures to investors.

********************

The working group rejected any proposal that would give the government the ability to inspect the books and records of hedge funds or force the funds to make regular reports about their activities. Both banks and brokerage firms must adhere to stringent rules that give regulators great leeway in supervising them.

********************

“Private pools of capital can be an appropriate investment vehicle for more sophisticated investors,” read one of the main principles that the officials and agencies agreed upon. “Because these pools can involve complex, illiquid or opaque investments and investment strategies that are not fully disclosed, the risk associated with direct investment in these pools are most appropriately borne by investors with the sophistication to identify, analyze and bear these risks.”

The report said that the concerns of less sophisticated investors in pension and retirement vehicles could best be addressed “through sound practices on the part of the fiduciaries that manage such vehicles.”

********************

“Too often, regulators reach immediately for new laws or rules which can have the unintended consequence of stifling innovation or smothering markets,” Mr. Green said. “By instead providing principles and guidelines, the President’s Working Group has recognized the importance of flexibility and efficiency in a healthy marketplace.”

Amen.

And for your reference, some links to previous posts on the issue of hedge fund regulation:

• 02/12/2006: The G-7 on Hedge Fund Risk: Politics Abound, But Getting the Right Answers
• 01/30/2007: "Implicit" Hedge Fund Regulation: Moving in the Right Direction
• 01/09/2007: Who Says Hedge Funds Aren't Regulated?
• 10/26/2006: More Mistaken Thoguhts about Hedge Funds - A European Perspective
• 07/27/2006: Do Hedge Funds Give Rise to Externalities?
• 07/16/2006: Much Ado About Nothing - the Hedge Fund Regulation Debate

One of my readers, Mark McQueen, who writes the Wellington Financial blog in Canada, put up a post himself on the results of the task force and the fact that the regulatory environment in Canada appears to be moving in the opposite direction of the U.S.:

This decision, which is against the wishes of the SEC, flies in the face of the draft rules released earlier this week in Canada by the Canadian Securities Administrators. And they appear to be aimed directly at the Canadian hedge fund community, according to the Globe, and is greatly influenced by what the Portus fellows pulled-off:

“Portus operated in the exempt market, selling products to wealthy investors, an area that would be more closely regulated under the new standards. Its managers would also now have to be registered under the proposed new rules. And the disclosure of referral fees was a particular concern with Portus, where investors complained that they hadn’t known their advisers had received large fees for steering them into Portus products.”

And in the wake of this regulatory dichotomy, Mark asks the following question:

But what about the Canadian office of a U.S.-based hedge fund manager that taps the Canadian market for limited partner capital? Should Fortress (FIG-NYSE), for example, not be subject to regulation but a Toronto-based Amaranth II would be?

Good question, Mark. What I will tell you is that fair or not, no U.S.-based hedge fund will be spending much time setting up offices or raising capital in Canada if this would cause them to be ensnared in a web of local regulations. It's just not worth it. So what will happen? Canada, because of its regulatory regime, will lose out on the innovation and talent fueled by the U.S. hedge fund community. And this would be a shame. But certainly not unusual - Governments enact rules and regulations all the time that have unintended adverse consequences, and this will just be one more to add to the pile (see Continental Europe - their pile is absolutely gigantic!). It remains to be seen whether such regulatory asymmetry will actually come to pass, but if it does, the big loser will be Canadian investors - not U.S. hedge funds. They'll figure out other places to raise a few bucks.

Google's TSO Program Revisited: Let's Get it Straight

I had a really busy day and was minding my own business when I came upon my friend Paul Kedrosky's post concerning the initiation of Google's Transferable Stock Option (TSO) Program. This is a topic I had written on back in December, taking a balanced view (IMHO) of the potential benefits of the program as well as the potential accounting artifacts. As I read Paul's post I said to myself, "Hey, I don't really agree with his points and think I'll write a little comment." But then I read a comment to his post that was so off the mark it got my blood boiling and I said to myself, "I think I'll write a more detailed comment to this post to get some other (hopefully clarifying) thoughts out on the table." Since this communication happened on Paul's blog and since I thought my comment was, well, really good, I wanted to share it here.

First, Paul frames the issue and provides his views on Infectious Greed:

A quick refresher: Rather than non-executive Google employees either exercising the options and selling at the current trading price (net the exercise price), or holding them and hoping for higher prices later, employees will be able to sell the vested options on a new secondary market created by Morgan Stanley. Among many other things, this would attach a value to vested options, even vested options having grant prices above the current trading price.

I have said previously that I like the innovative thinking, but I'm not yet convinced of the program. Two issues:

1. Where is the transparency? I have yet to see how outsiders get a window into this internal option market. I see how it's informationally good for Morgan Stanley and for participating institutions, but how do the rest of us get a window into the option flow data?
   
2. I see how this is good for Google employees, as well as for management in increasing the perceived value of options used in hiring engineers, etc., but I have yet to be convinced that it sufficiently aligns interests with run-of-the-mill investors. The idea behind grant prices, vesting, and exercisable options is to keep investors and employees' interests aligned. If Google employees can now make more money from options, and that doesn't imply an increase in shareholder value, which this doesn't, I'm uneasy.

Next, the comment that raised my ire:

1. Comment by Seth Finkelstein -- February 22, 2007 @ 9:10 AM

As I said earlier, check me on this:

Exercised employee options turn into stock. Which dilutes the stock. Which send prices down. Which leads to people exercising more options while they're worth anything . Which further sends the stock down ...

But if they can resell the options, to someone else, the party continues that much longer. ..

Options finance experts:

Is my cynicism correct?

No Seth, your cynicism isn't correct, not even close. Seth had previously written a post on the topic which was equally as nonsensical. Now I don't know Seth but I've read his blog and it's good. When he writes about stuff that he knows, which is almost all of the time. Why he would choose to write a missive (and it was a missive) on topic as complex and domain-specific as equity derivatives is beyond me but he did. And it irked me. And Paul, you are a dude but we have a slight difference of opinion.

Finally, my comment:

2. Comment by Roger -- February 22, 2007 @ 12:04 PM

Paul, as you may know, I wrote about Google's option program back in December (http://www.informationarbitrage.com/2006/12/google_and_cita.html). In it I discussed the pros and cons of the program, but basically came down in the "pro" camp.

Concerning you questions/issues, I get your point on (1) but over-the counter derivatives transactions are just that, over the counter, and they happen every day as a part of prudent capital structure management. There is plenty of options information available on Google from the public markets, so I'm not really sure I view this as a gating factor in viewing this program as positive. With respect to (2), IMHO you are missing the boat. This DOES create value - potentially significant value - for run-of-the-mill Google shareholders, by giving Management the currency to further incentivize top talent to join even in light of the stratospheric increase in stock price. And make no mistake, this was a BIG problem suffered by our friends at Microsoft (not to mention Intel) after they saw their market caps approach $600 billion and subsequently drop. By enabling employees to extract a measure of time value while preserving upside, you are creating an additional lever which Management can use to attract and retain the best-and-brightest. If I was a Google shareholder (which I am not), I would view this as a win.

Seth, sorry, but your analysis and earlier post are simply wrong. On both counts. Exercising stock options does NOT drive stock price down. Analysts (not to mention GAAP) utilize this concept called the Treasury Stock Method adjustment, which converts the in-the-moneyness of stock options and puts them in the denominator of the EPS calculation, ergo, the dilution associated with the rising stock price is already baked into EPS. And analysts who don't make these adjustments from a valuation perspective are simply idiots and should not be analysts. But to be clear, most do. Concerning your ongoing party metahpor, you have made the significant (and unlikely) assumption that employees view their choices at a point in time as being either (a) sell my option today and collect my in-the-moneyness and the lesser of (two years or the remaining life of the option) of time value (which is the deal Google agreed to with Morgan Stanley), while the option lives on in the hands of Morgan Stanley or (b) simply exercise the option. This will NEVER be the decision. Why? Because (a) will ALWAYS be worth more than (b). The choice is either (a) above or (b) exercise the option at a later date, because I don't need the money and continue to be bullish on Google's stock price. So the Morgan Stanley arrangement will NOT result in an extended option life. Fact.

I hope this helps.
Roger

Make no mistake, there are pros and cons to everything, and you can be sure that Google's TSO Program has some of each. But let's at least be clear, intelligent and intellectually honest about what's going on here; false criticisms and opinions based upon flawed assumptions just cheapen the value of what should be an important and incisive dialogue. This is what the blogosphere is all about.

 

Sirius and XM: A Synchronus Merger in an Increasingly Asynchronous World?

Overview

Needless to say, the blogosphere has been afire in the wake of the big merger announcement. And I'd like to chronicle some of these discussions here. But to sum up the tone, the key themes could be characterized by the following two statements: (1) "A reduction in competition is bad for both price and product quality;" and (2) "This is a merger of financial necessity, having nothing to do with better serving the customer or delivering a better product." These sentiments are intuitively logical and passionately felt by those who either subscribe to one or both products and/or have followed the evolution of satellite radio. Some other comments get right to the essence of the macro issue: is satellite radio really a product for the long haul, or will substitutes eventually chip away at the model and render its existence moot? Is SIRI/XMSR destined to go the way of Iridium? Is satellite radio kind of like an oil well, a fundamentally depleting asset that can be milked for a while before it runs dry? These are some of the questions that dominate the discussion, and absolutely need to be considered in the wake of this potentially (assuming the various mucky-mucks sign-off) historic merger.

I think there is little doubt of the financial motivation of the SIRI/XMSR tie-up. It reminds me a lot of the in-market bank mergers I looked at as an M&A associate in the late 1980s; it's principally about the cost savings, while some revenue accretion is possible due to increased pricing power. But this entire line of thought needs to be considered in light of the over-arching issue: is premium synchronous (real-time) radio worth it (for news, sports and other real-time media) in a world where the lion's share of content can be consumed easily, flexibly and cost-effectively in an asynchronous (time-shifted, on demand) manner? I think this is THE question for the long-term investor. Because if satellite radio is here to stay, economics at scale could look pretty attractive. But if not...

Camp #1: "This Merger Stinks"

This is view held by many Internet denizens in-the-know, including, yes, Doc Searls. I'm leading off with the Doc because his well-thought out view encapsulates the views of many out on the Internet.

From The Doc Searls Weblog 02/19/2007: A ground-level view of the XM/Sirius merger in the sky

There are a number of problems with this merger; but they're also problems with satellite radio in general:

• Antitrust. There are too few companies — just two — in satellite radio here in the U.S.; and soon there will be only one. Imagine if one company owned the whole FM band. It's like that. (Yes, I know Clear Channel sort-of does in many places, but what's dead about terrestrial radio is not on the table here.) The only thing keeping this merger out of antitrust territory is the still experimental nature of the whole medium, and the fact that neither company as it stands is known for its profitability.  (Sirius reported positive cash flow only late last year.)


• Program quality. The new company will presumably encourage production of radios that receive both services, which will be nice. But what will lack of competition between Sirius and XM do for programming on either of the former sides? There may be more money to buy better quality talent or whatever; but I find it hard to imagine how a drop in competition will improve anything. Which brings us to...


• Monoculture. I don't care how diverse the programming becomes, it's still coming from too few companies. When the choice gets down to one, I guarantee that programming will have a homogenous quality to it. There's already a self-sameness to both Sirius and XM, and that's sure to be the case with Xirius or whatever they call the new company. And I say this as a generally pleased Sirius customer. At some point Xirius' homogeneity will not compete against the absolute heterogeneity that listeners already find outside the walled garden(s) of satellite radio.


• Obsolescence. When the two services started (around a decade ago), a total of 300 different "channels" (around 150 apiece) seemed like a lot. The program choices for listeners on either XM or Sirius far exceeded the sum of available sources from terrestrial radio. But now the sum of all program choices runs into the thousands or perhaps even millions. Yes, satellite radio is live while most of the other choices are just stored files; but files are easier to distribute and lend themselves to iPod-style listening. (On the "T" this morning here in Boston, I noted that a quarter of all the commuters in my subway car were listening to something on earphones. I'm sure it wasn't radio — satellite or otherwise.) As Dave says, listeners want to program their own "stations". Many listeners, which we used to call "consumers" are now also producers, for themselves and others. Where does satellite radio fit in that picture? I don't think even Mel Karmazin knows. Meanwhile, the whole system continues to leverage an understanding of How Radio Works that is, to say the least, not current — much less future-proof.


• Costs. The running costs of maintaining satellite radio infrastructure is high, to say the least. Too high? Not as long as the company remains profitable. Which brings us to...


• Revenues. Subscriptions may be enough. But if they're not, what will happen when something better obsoletes the kind of advertising that has sustained radio for the duration? I may be wrong about this, but I've long believed that the inherent inefficiencies of broadcast advertising will doom the model in the long run. I haven't been right yet about that, so feel free to continue not believing me.

I'm not saying I don't approve of the merger, by the way. If this is what we need to keep satellite radio alive, all the better. But I think it's important to keep the downsides in mind — not just for the merger, but for satellite radio itself.

From Poplicks.com 02/19/2007: Xirius Satellite Radio - An uncivil union

Today is another sad day for music.  I'm gravely disappointed to hear the news that XM and Sirius are planning to merge.

Even though FCC rules forbid one from buying out the other, their financial problems will probably lead to an approval of the merger, especially with this monopoly-friendly administration. I doubt XM or Sirius stockholders will stop this unholy marriage.

Even though this merger will surely lower both of their operating costs, this money-grubbing alliance can only lead to higher monthly fees in the future, more commercials, and the eventual squashing of voices and artists that satellite radio has managed to introduce into many pockets of the continental US.

********************

The obvious point of this rambling post is that the competition between XM and Sirius has forced both to constantly offer more diverse programming, deepen their catalog, cater to specific groups (e.g., there's a Korean language channel on Sirius!), and, to some extent, play fewer commercials.

But after an XM-Sirius merger, I can easily imagine that satellite radio will soon be only marginally better than terrestrial radio, which is like saying that herpes won't be as bad as cancer.

Ouch. That's pretty brutal, but a sentiment shared by many. Check out this post from stereogum. By the way, you really need to click through to read this post because the comments are terrific.

From stereogum.com 02/19/2007: XM AND SIRIUS HAVE THE URGE TO MERGE

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But whatever, this is where they are, bound by their budget books to come together, hoping it'll save 'em from insolvency. But most importantly for you, the subscriber: There's no more competition! Instead of two companies desperate to lure your subscribing dollars via superior content, the monolithic beast will be able to frame their product simply, in a can't lose scenario: "It's us or terrestrial." Where XM and Sirius could have pushed each other to develop interesting new programs and a keep a commitment to good, quality playlists, they'll now be able to rest easily on the medium's inherent trump card: commercial-free music. We don't subscribe (though we used to have Sirius); we're good with our iPods and Peel.  But the loss of another potential filter for new music is a bummer. Granted, the merger may be financially necessary; but does anyone actually think it'll create a better product?

This tone of resignation related to the merger - due to its necessity for financial reasons - is vastly offset by concerns over the impact on competition, and its effect on the quality of the product and the price of service delivery. But look at the breadth of views from some of the comments to this post:

Admittedly, I haven't listened to XM for probably about a year, but the programming I heard was like the "all music" channels you get on cable...song after song, no real feel for continuity or groove between songs, no DJs. Which you would think would be cool, but like the all music channels on cable, isn't. The lack of DJ really bothers me for some reason; without one, it's just mindless. Chuck: I'm guessing they'll just re-broadcast the redundant programming across two platforms until the "new" receivers come out. But that had better not render my old receiver useless.

Posted by: Ferris at February 19, 2007 10:06 PM

First, if they merge, there will be no more competition in the satellite radio market. With one firm, there is little reason why a company would want to provide a better product. Financially necessary? What the hell is that? They want to merge into a monopoly, make more profit, and say "to hell" with the consumer.

Here is an illustration: Do you live in a city with one cable company? How are prices? Do you like them? Do you think the service could be better? Of course, you do. However, the municipality has given your cable company the sole franchise for cable service. With the government backing them, why would they want to change or provide a better service?

Basically, competition tends to drive prices down and increase quality.

I'll await the FCC's ruling on this horizontal merger.

Posted by: brad at February 19, 2007 11:39 PM

Of course XM/Sirius will have competition. It's called Internet Radio and it is (usually) free. Unless you specifically want to listen to Howard there are probably 1,000's of IR streams that are programmed as well (or better) than satellite. Satellite is more mobile for now, but that is changing too. I regularly listen to IR on my Treo on the train & walking around town.

>Posted by: Jim at February 20, 2007 10:18 AM

Let's face it: consumers and investors alike are groping around trying to figure out what all this means. Except for the clear and present concerns over perceived lack of competition in satellite radio, the online commentary is all over the map.

Camp #2: "Who Cares About the Merger - What About the Business Model?"

There was a very interesting post on BusinessWeek.com today that made the argument that satellite radio is not catering to the savvy, younger demographic, specifically those who leverage asynchonous channels to get their content in the absence of a compelling synchronous offering.

From BusinessWeek.com 02/21/2007: Satellite Radio Falls on Deaf Ears

My 17-year-old ought to be the target audience for Sirius Satellite Radio (SIRI) and XM Satellite Radio (XMSR), the two competing companies that now are asking the Federal Communications Commission for a green light to merge. After all, she spends much of her life with an ear glued to anything that will satisfy her urgent need for the soothing vibrations of Blink-182, the White Stripes, and a bunch of other groups that may have come and gone by the time you read this. Apple's (AAPL) iTunes is the start page on her computer, and she plugs her iPod into her 1999 Jeep. Her computer, well, that plays tunes as well, usually when she's cramming for a test.

But ask my Madeline whether she'd like a subscription to one of the satellite radio companies and you'd get a blank stare. Tell her that it costs $12.95 a month, and she'll quickly calculate that it's the equivalent of 13 iTunes downloads. In short, the folks who think they'll one day make a market out of signing legions of folks who want crystal clear radio signals might just as well try to sell Madeline a landline telephone. You're yesterday's consumer product even before you've found a market. A decade or so after opening business, the two services have, they say, around 14 million subscribers—or a little more than half the number of folks who bought iPods from Apple in the past quarter.

********************

Bernoff doesn't necessarily share my downbeat assessment of satellite's future—he rightly points out that people will still pay for convenience, quality, and choice—and he figures wall-to-wall Howard Stern, easy listening, or other types of music qualify on all scores.

He may have a point. There are plenty of those out there who want to hear their radio sans advertising, in a nice, crystal clear sound, without the crackles. But I take my cues from Madeline, whose generation represents the future of the media business. And they want their media in a much more convenient form than Sirius and XM can give it to her—like now. If they want to hear Howard Stern (and, thank goodness, Madeline doesn't) they want to download him, or get a podcast of his latest show. And if they want music, they want it on their own terms, whether it's in a car, a laptop, or from those iPod headsets that seem to dangle from the ears of everyone under the age of 35.

Yes, yes, I know that the satellite boys understand all of this: They offer online subscriptions, specially made radios to deliver their signal. I get it. But Madeline won't. And that's the problem, guys.

I personally find this line of discussion quite compelling and worthy of consideration. Where does the high-value demographic reside? How do they consume digital content? Who are the key influencers that can jump-start a brand without a $1 billion advertising and marketing campaign? Today's young thought leaders know what they want and know when they want it, and simply use technology as the means to get it fast, quickly and cheaply. Their time is their own, and they don't want to operate on anyone else's schedule. Remember DVRs? A world without ads, except those you choose to see? This is not the world of satellite radio, but more the world of Apple. So what about Apple? Apple flirted with Mel and Sirius back in 2005, only to spurn them:

From CNNMoney.com 02/09/2005: No satellite radio for iPod?

NEW YORK (CNN/Money) - Mel Karmazin, the new CEO of Sirius Satellite Radio, said he's talked recently with Apple Computer about adding satellite radio to its popular iPod music player.

"I've spoken to (Apple CEO) Steve Jobs," said Karmazin, speaking Wednesday morning at a media conference in New York. He declined to elaborate, other than to say that the "current thinking" at Apple (up $0.40 to $81.30, Research) is that "they don't need to put a satellite radio in their box."

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April Horace, a satellite radio analyst with Janco Partners, said the consensus among industry watchers is that satellite radio and the iPod would be "the killer app." Apple's apparent apathy aside, she said there are significant legal and technical hurdles to clear before satellite radio can be added to the iPod or any other MP3 player like it.

"Do I think (a satellite radio-MP3 player combo) is going to happen some day in the future? Absolutely," said Horace. But whether XM or Sirius nabs Apple or another MP3 maker like Sony or Virgin first is anybody's guess, she said.

Awww, poor Mel. But the recent merger announcement has rekindled thoughts that maybe, just maybe, the time is right for Apple and SIRI/XMSR to discuss satellite radio integration with the iPod.

From digitalmediawire 02/20/2007: Does a Sirius and XM Merger Make Way for an Apple Deal, iPod Integration?

Although dismissed as a possibility for a long time due to anti-monopoly laws, the satellite radio rivals Sirius and XM on Monday announced that they were going to try to do the sensible thing and merge into one company. Legal issues aside, the interesting question is now how the combined forces of Sirius and XM will stand up against other formats of music consumption? The announcement specifically mentioned the threats from "iPods and mobile phone streaming". This is where the focus rightly should be - the merger should be seem in the light of increased pressure to compete with not just radios, but with the digital music players that replace them.

The news of the merger resurrects the possibility of iPod integration with satellite radio. This idea has been killed off by Apple CEO Steve Jobs after negotiations with Sirius chief Karmazin “failed to impress” (see Financial Times article here). Jobs mentioned a lack of interesting content as a key obstacle back in 2005.

If and when Sirius and XM are allowed to merge, that would mean many more channels in one place, once some of the fat has been trimmed off. Moreover, the blog AppleInsider notes that Apple is certainly no stranger to the concept and was caught trademarking the possibility of satellite music streaming in its enigmatic “Mobile Me” application.

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Now that's kind of interesting. Big question is whether anything much has really changed since Apple said no to Mel two years ago. Does the value Apple gets from synchronous media really offset the costs and complexity of such a deal, especially when the core of its user base has grown up with an asynchronous mind-set? I'm not so sure. Anyway, it makes for interesting conjecture.

Camp #3: "It's Big, It's Complicated, But it Could be Good"

Even in the wake of the announcement life goes on, especially given the long and rocky regulatory gauntlet this deal will have to run before getting approved. So far, from the consumer end, this uncertainty doesn't seem to have adversely impacted sales of satellite receivers.

From Postbulletin.com 02/21/2007: Sales of satellite radio receivers remain steady

What kind of reception is a proposed merger between the two satellite radio providers picking up from Rochester music and sports fans?

Sirius Satellite Radio and XM Satellite Radio announced the plan earlier this week, and it doesn't seem to have hurt sales of each company's equipment.

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The proposed merger, however, has clouded the issue of which company offers which -- sports or music.

"Some people are buying (equipment) because they say it will be lumped together," Conard said. "They say it won't matter (which system you choose) eventually."

XM radio receivers can't receive signals from Sirius and vice versa. The companies are working on developing a receiver that could receive both signals.

In the meantime, they said, assuming the deal goes through, the companies would make other arrangements to provide programming that's currently exclusive to one provider to listeners of the other, such as getting Major League Baseball games -- currently only available on XM -- to Sirius listeners.

From TECHNORIDE 02/21/2007: How the Sirius-XM Merger Affects You

Sirius and XM combined will likely provide more services to customers, who will no longer have to worry if they've made the right choice between buying Sirius hardware and XM hardware. But the cost of service will go up, and I wouldn't be surprised if your monthly bill hits $20. At the same time, every car built from 2010 on will have a satellite decoder standard in the car's radio. That's my take on the effects of the merger: more choices, and more costs.

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A combined channel would have all the sports, but most likely some or all would be premium channels. In the merger announcements, Sirius and XM talked about providing "a la carte" opportunities. Translation: "a la cash register." You'd also have the opportunity to get both Howard Stern and Oprah Winfrey, instead of Howard on Sirius and Oprah on XM. But they, too, may be a la carte.

Most subscribers are annoyed they can't get all the sports programming on both the satellite channels. With the merger, they could. But I don't see any near-term mobile (in-car) audio alternative that will offer all sports programming across the country, as opposed to the Bruins in Boston, the Capitals in Washington, and so on. And satellite—both TV and radio—has been a godsend for, say, the Philadelphia sports fan who now lives in San Francisco. With no competitive pressure, there's room for a combined provider to see just how much the market will bear, the way Disney World does with admission prices.

A single company's pooled resources might be better able to fund satellite TV to the car over satellite-radio frequencies. For a DirecTV experience that's the same as in your house, with dozens of channels, you'd still need a three-foot revolving dish (such as TracVision provides). But a couple of channels of child-entertainment fare could happen inside five years. A la carte? Of course.

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So this camp is acknowledging of the possible risks of the merger, especially as it relates to pricing, but is more hopeful as it relates to delivering a satisfying all-in-one product with greater breadth and depth than either has alone, with the benefits of greater financial resources to deliver an increasingly robust array of content. This doesn't sound so bad. And it is good to see that consumers aren't paralyzed in the wake of uncertainty. At least those who were intending to buy are still buying. But is the merger announcement stoking fresh demand? Too early to tell, but I'd strongly doubt it.

Conclusion

Clearly the jury is out, but cynicism abounds as to the consumer benefits of the merger. Less competition, less incentive to create new, high-value content, greater pricing power, none of this good for Jane and Joe Consumer. Yet many, if not most, acknowledge the financial rationale (if not the necessity) of the deal. That said, there is a meaningful camp that questions the long-term viability of the satellite radio business model, particularly in light of the wide and growing array of programming substitutes available in an asychronous, on-demand fashion. And this appears to be where much of the growth in digital media resides. So where does this leave Sirius and XMSR? Good question. And certainly a challenging one for investors.

The author does not hold a position in the securities of these companies.

My Interview with FT Alphaville

Stacy-Marie Ishmael of the Financial Times published a wide-ranging interview with me on FT Alphaville yesterday concerning Monitor110, Information Arbitrage and extracting investable information from the Internet. It is likely the most in-depth and comprehensive discussion of my background and current passions that I've given, and Stacy-Marie did an amazing job capturing my words in the context of a long, rambling discussion (she asked pointed questions - I did the rambling).

I also called out four of my favorite bloggers when pressed - Fred Wilson of A VC, Mike Seneadza aka Trader Mike, Barry Ritholtz of The Big Picture and Guy Kawasaki of How to Change the World. I told Stacy-Marie that I read about 200 blogs and have many favorite bloggers, but I couldn't include all of them in my response. Sorry to those not specifically mentioned. You know who you are and you know I'm a fan.

Baidu Revisited: The Heat is On

Overview

Google vs. Baidu. This has been and continues to be an interesting battle between the hometown favorite and the global titan, with the hometown hero decisively winning the first few skirmishes with the global godzilla waking up from its slumber and getting down and dirty, real fast. I had written about some of the good and bad at Baidu back in December, and many of the issues I had raised almost three months ago are still in play today. However, it appears that Google's persistence, ability to listen and learn and long-term focus has caused it to rapidly close the gap, posing a real threat to Baidu in its home market. Further, some Baidu missteps are hampering its own efforts to continue its meteoric growth in China and to maintain its hometown advantage. So while many have seemingly crowned Baidu the victor in China, well, let's just say that I'm not so sure.

And it is important to keep in mind that as China continues to inch ever closer to the West, whether it is due to the image it wants to portray in advance of the Bejing 2008 Olympics or the position it would like to secure on the global economic and political stage, this can only work to Google's advantage. Superior technology, global footprint, vast financial resources, long-term view, "Do No Evil" ethos resonating with the leading edge of the Chinese Internet denizens - all of these speak to an ascendant Google in China even as Baidu is the nationalists choice for search. Bottom line: China's 140 million Internet users are smart, savvy and want the best. And no amount of nationalistic feeling will keep them from using the superior tool. And this tool, my friends, is likely to be Google.

Google - China is a Tough Place to Play

It is hard getting your teeth kicked in repeatedly, as Google's were for much of 2006. Look at the tone of this post on the Google Blog from about a year ago (01/27/2006):

Google users in China today struggle with a service that, to be blunt, isn't very good. Google.com appears to be down around 10% of the time. Even when users can reach it, the website is slow, and sometimes produces results that when clicked on, stall out the user's browser. Our Google News service is never available; Google Images is accessible only half the time. At Google we work hard to create a great experience for our users, and the level of service we've been able to provide in China is not something we're proud of.

This problem could only be resolved by creating a local presence, and this week we did so, by launching Google.cn, our website for the People's Republic of China. In order to do so, we have agreed to remove certain sensitive information from our search results. We know that many people are upset about this decision, and frankly, we understand their point of view. This wasn't an easy choice, but in the end, we believe the course of action we've chosen will prove to be the right one.

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We're in this for the long haul. In the years to come, we'll be making significant and growing investments in China. Our launch of google.cn, though filtered, is a necessary first step toward achieving a productive presence in a rapidly changing country that will be one of the world's most important and dynamic for decades to come. To some people, a hard compromise may not feel as satisfying as a withdrawal on principle, but we believe it's the best way to work toward the results we all desire.

They know what they've gotten themselves into. And yes, they took a ton of crap for agreeing to work with the Chinese authorities to filter certain "objectionable" content from their search results (how does this follow the "Do No Evil" code?). But as forward-thinkers and as capitalists, they understood that they simply couldn't cede one of the largest and influential Internet markets in the name of a rigid set of principles. Things change, situations evolve, and being flexible without "selling out" (at least to yourself) is both very emancipating and very smart - certainly for Google's shareholders.

But hey, a year has gone by and Google has made terrific headway in China. Having a significant local presence has done them right, taught them a lot and much of the negative press associated with their decision to filter pursuant to Chinese Government demands has gone away. Now it is Google and Baidu. And even as the China opportunity is largely untapped (with less than 10% penetration of the population), Baidu is looking elsewhere for growth. And this is because...? Good question.

Baidu - In the Lead, But Distractions Abound

Baidu is the leader in what likely represents the largest and most rapidly growing search market on the planet. Then why is it in such a rush to diversify away from its home market? I asked this question back in December and still haven't gotten a good answer from the Internet or anywhere else. Consider this recent post from irreverant stock list from 02/17/2007:

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They are now trying to expand into Japan, but why? If China offers so much opportunity for growth, why not try to maximize their presence there first and then consider expansion into Japan? The capex expansion just to establish its presence in Japan is ludicrous! Do I have to remind everyone that China and Japan aren't exactly best buddies? In addition, search market in Japan will be a hard nut to crack with Google and Yahoo already having presence in that market. So why are they doing this when their revenue is now declining in China? The PE of 138.90 is based on the premise that they can continue to grow their earnings. This does not seem to be the case.

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What does all this mean? I expect that earnings will taper off as a result of this within the next 3 quarters and with continued competition from SOHU and Google, it will only get more difficult to grow. The Chinese internet adoption rate is at its early infancy with less than 10% of the population penetration. Perhaps that is why they are trying to enter Japanese market for additional growth. To me, it just doesn't make much sense.

Hmm. Good questions. From the Japanese side, there has been an initiative to try and develop a local search engine catering to Japanese web users, but as this is being spearheaded by a Government agency (METI) the results have been predictable - none. That said, an interesting post from the Japan Economy and News Blog from 02/16/2007 highlights the incredibly competitive environment in the Japanese search market:

Back in December of 2005, Japan’s Ministry of Economy, Trade and Industry organized a study group comprised of about 20 Japanese electronics companies and universities, which was supposed to consider the merits of creating a search engine designed specifically for Japan’s Web users. Asia Media reported that the study group would include such giants as Matsushita Electric Industrial (Panasonic), Hitachi, NEC and Fujitsu, Nippon Telegraph and Telephone and public broadcaster NHK.

Also at that time, the Nihon Keizai Shimbun reported that Japan’s effort would be aimed at competing with Google. That interested me, since Yahoo is by far and away the search/internet portal market share leader in Japan. Google, of course, is the company that everyone thinks of as being cutting edge. Oh yeah, and Google makes heaps of money.

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Yesterday, Baidu announced that its quarterly profits had quintupled,  and that it would continue with plans to invest $15 million to get the Japanese version of its search engine up and running.

Baidu, of course, is aware of the difficulties involving such a project. As Shaun Rein, managing director of Shanghai-based China Market Research Group, put it:

There are a lot more embedded competitors in the Japanese market than in China [when Baidu got started]. [In China,] Baidu wasn’t really competing against anyone with a strong position. [In Japan,] Baidu is going against people who really know the local market.

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The next few weeks should be interesting. Will the possible entrance of a Chinese competitor finally inspire METI to get its act together and get a project running? Is it possible to retain the flexibility needed to run a successful search engine while attempting to enlist 20 organizations to cooperate? Or - and this is what this observer is hoping for - will a Japanese start-up enter the fray and attempt to brand itself into the Japanese source for search?

Large, well-funded, embedded competitors. Substantial cultural barriers. Seemingly massive growth opportunities in its home market. Why is Baidu doing this? Do they see their own weakness and rising threats on the domestic front? Or are they simply making the classic error of overconfidence by extrapolating their home-market success into foreign markets, and straining both managerial and financial resources in the process? Either way, the prognosis is not good. Something just doesn't add up.

China - Censorship is a Way of Life

Regardless of how much progress China appears to be making in dealing with the West, the issue of censorship continues to rear its ugly head. From Adotas 01/24/2007:

At a session of the Chinese Communist Party’s Politburo, President Hu Jintao called for better regulations for Internet content to ensure the development of a “actively and creatively nurture a healthy online culture,” according to the government’s news agency.

Faced with a rapidly increasing Chinese online population, President Hu called on the government to use new technology and techniques to influence public opinion and improve Internet security. According to the Shanghai Academy of Social Sciences, in two years, China could house the largest number of Internet users in the world, surpassing even the United States.

China’s Internet population increased by 23.4% in 2006, according to the state-run China Internet Network Information Center. Meanwhile, the Agence-France Presse reports that the US audience has grown only around 2%. “The growth now is gaining much momentum. We’re expecting even faster growth in 2007 and 2008,” said Information Center director Wang Enhai in an interview with the government-owned China Daily newspaper.

See those growth numbers? And off a pretty large base to begin with. Stunning. More on censorship.

From Baidu.com 10/18/2006 - Does Baidu have the right to delete users' articles?

The most important thing that I was working on was suddenly deleted earlier and there was no basis for your deletion. We understand that you are entitled to delete political criticisms, but you have exercised too much authority by deleting the other articles.

From Daai Tou Laam 02/15/2007 - The Sentence Overlooked

The professors weren't protesting CCP censorship as an abstract evil. The professors seemed to understand and accept the expected boundaries of CCP censorship. It was only when blog posts that should have made it in to print in the mainland press were deleted without notice, that they started to protest Sina's actions. It was when the censorship crossed from clearly defined boundaries in to an unclear haze, that writing and decision making about what to write and the process of censorship became untenable. It was when news topics would disappear from the public dialogue like purged Soviet Politburo members from photos, that censorship became "a behavioural code on the internet" that was unacceptable.

This is an issue that just won't go away and impacts all competitors in the Chinese market, not only those based on foreign shores.

Baidu - Funny Business Just Isn't Funny

There are a wide array of feelings towards Baidu inside of China. First, the positive:

From Baidu.com 12/18/2006 - Support Baidu, No Google

Please support or own Baidu and keep Google out of China. Google has tons of advertisements and the company deducts a premium from web owners. This victimizes those who adertise, unlike in Baidu which does not practice malicious competition.

Uh huh. There have been lingering concerns around Baidu's search results, especially when compared with Google. I had written a post about this back in August, when Baidu was subject to scrutiny in the wake of a click-fraud scandal. Here is an extract from that post concerning the alleged manipulation of search results:

Yet another interesting topic is the potential manipulation of search results. Remember that Office Space reference above? Well, Baidu fired 45 employees in two hours in a fairly uncermonious fashion. One such employee actually recorded their interaction with Human Resources and the translated transcript can be found here. This isn't so bad - every large company has their Vault-posted nightmare HR stories. What I found particularly interesting is that a friend of mine in China ran a search on this issue in both Baidu and Google with vastly different results - Baidu came back with only about 6,700 returns, while Google's count was closer to 45,000 (that's not a typo - we're talking 7x the number of Baidu). I am also told that Baidu generally does better on these types of searches than Google. So what's going on here? Good question, but the implications are certainly not good.

Could it be that Google is creating an open, fair, understood market, while Baidu is still battling with unfair and opaque business practices? There is a bunch of data out there, both new and old, about Chinese Internet users who are enraged by Baidu's Pay for Placement Bidding Service (BPPS) and how it is used to manipulate search results.

From an angry Chinese poster dated 01/13/2007 who complained that his website was screened out because he refused to join BPPS - Strongly against Baidu!

Our website www.ldf.owner.com has been operating for five years and the hits have been relatively stable. We refused when offered by Baidu as we intend to promote competitive bidding. Later on we found that our website recorded sharp falls. What was originally includedin the more tan 10,000 pages have now declined to five pages. Baidu is really unfair!

From Interfax.cn dated 02/02/2007 concerning the pay-for-placement issue

Shanghai. February 2. INTERFAX-CHINA - Canada-travel.cn has appealed to a higher Beijing court in a case involving Baidu's pay-for-ranking service, the Web site's lawyer said. 

The ruling in the case is expected to set a legal precedent in the search engine business, and bring some common agreed-upon rules to the industry.

Canada-travel.cn is a customer of Baidu's bid for placement service which gives listing priority to sites that are willing to pay. Usually a site purchases ten or more keywords from Baidu, and its name will appear on top of Baidu's search results list.

According to Zhang Lurong, the site's lawyer, Canada-travel.cn was within the top 10 or even the top 5 until the end of 2005. But in March 2006, the site's ranking fell dramatically.

"The link appeared after the 70th page of the search results. Often, it wasn't even in the top 1,000," said Zhang. "However, we checked the rankings over the same period on Google, Yahoo, Zhongsou and Yisou, and none of those had changed."

"After their ranking dropped, Canada-travel.cn received calls from a Baidu salesperson asking them to buy another ten key words," said Zhang.

After the site complained to Baidu, the search engine "suddenly" adjusted the ranking to its former level, with an official reply citing many reasons why a site might be banned, such as spam links.

However, the company felt the abnormal ranking was a malicious activity Baidu conducted in order to profit from its bid for placement business. Therefore, they sued Baidu in September, accusing Baidu of unfair competition and seeking compensation of $12,810.

"Many small sites encountered this situation before. They came to me and tried to sue Baidu, but it's hard to acquire evidence," Zhang said. "This site's situation was special because Baidu later recovered the site's ranking. We saved the comparison and did notarization.

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However, to date, 8148 people have registered on fanbaidu.com, the official site of an anti-Baidu alliance joined by angry site owners, mostly owners of less well-known small and medium sites.

Many of these members said their sites were banned by Baidu because they were unwilling to pay for their rankings.

Huo Xiaochuan, the director of Baidu's customer service department in Shanghai, said he never received such complaints, and he refused to comment on the anti-Baidu alliance.

However, the owner of several sites, Mei Xiaoming, said he complained to Huo directly many times.

"I kept all the evidence about the ranking changes. At first, Baidu staff denied it but finally they admitted. But they attributed the reasons to other departments in the company, so until now, the ranking of my site has not been recovered," said Mei.

We'll see how Canada-travel.cn fares in court, but in the court of public opinion this is not a good fact pattern for Baidu. And these are serious problems that were cited over seven months ago. And it does not appear that Baidu is in any way admitting responsibility. This form of denial in the absence of evidence is generally not successful in a web-enabled world, a world which has now found China and represents a body with a voice - a loud voice that can vote with clicks and their yuan.

02/06/2007 - Comparison between the search results of Google and Baidu

Google puts page rank into consideration when searching, unlike Baidu which generates lots of results but mostly garbage.

02/08/2007 - Baidu announces to launch data service but some experts questioned its justice

Baidu launched "Press" mainly for their own publicity. Baidu's fairness was questioned as it gains rom the advertisements' pricing and not the business owners who advertise.

02/07/2007 - The search results of Baidu are exaggerated

Baidu's massive search results have a problem, there is improper handling of search results. Some are subjective and signify unfair competition.

This kind of chatter coming from home-market users is clearly not a positive indicator. It is not so much the issue of complaints (I mean, what successful business doesn't have complaints?) but the nature of the complaints - fairness, lack of transparency, dishonesty. These are worrisome trends that do not seem to be abating. What this means for Baidu's competition with Google is unclear, but it certainly can't be good.

Google - Getting Serious, Getting Some Props

Though not the home market leader, Google is getting some positive recognition in Chinese Internet circles. Part of this is undoubtedly due to some degree of "Westernization" happening within China, a more business-oriented, savvy mind-set and an increasingly open mind as it relates to all things Western.

From Zunch 02/13/2007 - Google Piles on Features in Asia

Google is adding maps and word processing services to its Chinese site in its ongoing fight to grab a bigger share of the search engine market in China.

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Whether the average Chinese citizen will switch to Google remains to be seen. As evidenced by its marketshare, over half of all Chinese currently prefer Baidu. But don't count Google out.

As the Internet continues to shrink the world (so ot speak), expect the Chinese to become more trusting of Google. Especially if they happen to be a Chinese company wanting to do business with Western nations.

From Meta 02/09/2007 - An Open Letter to Google Founders - to save Google in China and save Internet in China

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Google is not alone. There are still several millions Google fans in China, especially those bloggers who are more real time intelligent to outside world.  If Google do good as they did in early days. There will be more supporters for sure. Google is not playing a game of itself. You may  under-estimate that before with limited information sources. People here are looking forward  that you can pick the three suggestions(or partly) as China strategy in the coming years which can keep Google's "non-evil" motto alive in people's mind. It will also benefit to Google's business in China. It will be also benefit to the whole Internet neutrality in China. All the Internet users will appreciate that eventually.

All of all, the pure the better; the more compromise, the worse.

All I can say is, WOW. This is one passionate post. And he is right; Google is not alone. Many in China appear to view Google as legitimate and attractive alternative to Baidu. This positive momentum really started at the beginning of 2006 in the wake of Google's admission of its lousy performance in China. It needed to be more local. It took steps to do exactly this. And it paid dividends during 2006. And it appears that those dividends are only getting larger over time.

Conclusion

Google vs. Baidu is shaping up to be a real fight, not the way it appeared only a year ago. Google has scraped itself off the mat, put in its mouthpiece, inhaled some smelling salts and is girded for battle. Given its business model, its culture, its its push to be local, its financial resources and its commitment to win in China, it is hard to bet against them. Baidu has a massive lead and the hearts of a large portion of the Chinese Internet community, but the long-term battle will be won on the basis of performance and trust. And right now, it appears that Baidu is having some serious problems. Serious. Problems.

The author does not hold a position in this company's securities.