IPG Photonics charts up to Q3 2015

Disclosure – I’m long IPG Photonics Corporation (IPGP).


My main source of data is IPG’s SEC filings page, with some info from the Prepared remarks on the Presentations page and the results releases on the Press Releases page. Some “net sales” figures were reported as “revenue” outside of SEC filings, and in previous quarters I’ve confirmed that when both terms were used for the same quantity, they had the same figures.

I’ve also quoted from “IPG Photonics (IPGP) CEO Valentin Gapontsev on Q3 2015 Results – Earnings Call Transcript” Oct. 27, 2015 (www.seekingalpha.com).

Annual data

There’s more annual data charted in my piece “IPG Photonics – charts up to Q1 2015”, on Seeking Alpha and on my blog site, including the growth of sales in China and assets in Russia.


I don’t mean to imply that the quarterly twitches matter more than the general trend. The best entry points might be when quarterly results disappoint, although the market is capable of worrying ahead of results. For example recent share price weakness has been attributed to concern about China, see “IPG Photonics up 9.2% following mixed Q3 results, soft Q4 guidance” Oct 27 2015 (seekingalpha.com). The results were reassuring about China, which explains the rise, but that followed a 5% drop (see IPG Photonics misses by $0.03, beats on revenue).


Charts showing guidance are based on this from the prepared remarks:

    “We currently expect revenues for the fourth quarter to be in the range of $215 million to $230 million. We anticipate Q4 earnings per diluted share in the range of $1.00 to $1.15. The mid-point of this guidance represents quarterly revenue growth of approximately 7% and EPS remaining flat, respectively, year-over-year.

    The EPS guidance is based upon 53,392,000 diluted common shares, which includes 52,675,000 basic common shares outstanding and 717,000 potentially dilutive options at September 30, 2015.”

Income, revenue and costs

IPG results to Q3 2015 bars and line

About seasonality, the 10-K for 2014 has –

    “Historically, our net sales have been higher in the second half of the year than in the first half of the year.”

and from the Prepared remarks –

    “While the book-to-bill was slightly below 1 in Q3 2015 this is not unusual because we typically expect the fourth quarter to be seasonally weaker.”

Taken together, Q3 must be seasonally strong. That’s consistent with the chart above, although there was also a strong Q4 in 2014 due to exceptional orders as pointed out in the middle of this –

    “The Q4 guidance represents about 7% revenue growth at the midpoint over Q4 2014. I want to point out that our guidance range includes double digit growth in Germany, Japan and China. Year over year we expect Q4 revenue in China to grow at about 15%. While this represents a lower rate of growth as compared to the year-to-date it is still pretty good. What is pulling down the overall Q4 expected growth rate is the U.S. which had a very strong Q4 2014 with shipments of several super high-power lasers and a large automotive order. Revenue in the U.S. is more evenly spread between Q3 and Q4 this year rather than being weighted to Q4. In addition, we are expecting a slightly weaker quarter in Turkey and Korea where macro-economic conditions have softened.” (Prepared remarks)

In the next chart, “Operating expense plus tax” is actually Operating income – Net income, and includes a small amount of “Other income, net”.

IPG results to Q3 2015 stacked

IPG EPS to Q3 2015

IPG EPS growth to Q3 2015

Revenue and costs are affected by currency exchange rates –

    “IPG delivered yet another strong quarter, growing revenues by 22% year-over-year to $243.5 million in the third quarter of 2015. We translated that growth into a gross margin of 54.7% and we reported EPS of $1.18 which includes a $0.06 per share impact of foreign exchange transaction losses. Year-over-year, foreign currency losses reduced our sales by 12 percentage points. In other words, sales would have increased 34% if Q3 2015 exchange rates remained the same as a year ago.” (Prepared remarks)

The only hedge I found was an interest rate swap associated with the U.S. long-term note, worth a notional $11.3 million in 2014, which matured in June 2015. I’ve seen no evidence of currency hedging with derivatives, although the company said they analyze exposure and might use financial hedges. Encouraging faster payment in China was presumably more cost-effective, and also benefits customers rather than giving business to financial counterparties.

Other comprehensive income, exchange rates and dollar debt

As well as affecting how revenue and costs are translated into dollars, exchange rates also affect the dollar value of overseas assets, and the change in the value is recognized in Other Comprehensive Income –

IPG Net income and OCI to Q3 2015

The dollar is probably in long term decline, though with big swings (for the dollar index since 1971, click here then click “Historical” and “Max”). That suggests that in the long term, IPG will accumulate an OCI gain instead of the current accumulated OCI loss of $155.8 million. There’s some risk of further dollar gains before reversion to the trend.

I’ve warned for nearly a year that overseas dollar denominated debt could trigger a flight to safety that could push up the US dollar. The debt problem is explained in “Bond Issuers and Investors Are About to Find Out It’s Not Easy Being Green(back-Denominated)” by Tracy Alloway, August 24, 2015 (bloomberg.com). I don’t have the author’s certainty about it, due partly to a lack of evidence that borrowers don’t earn enough dollars to repay the debt. If it all goes bad, many companies would be affected. I’d rather be holding IPGP with the industry-leading margins, good free cash flow and big stash of cash than many other stocks.

The concern includes China, as in “China’s dollar debts come under pressure” by Michael Mackenzie and James Kynge, August 11, 2015 (ft.com) (you probably have to answer a market research question to see the article). There may be less impact on US firms if the debt is mostly held by local government and real-estate firms (see “China’s Big-Dollar Borrowers Hold Off on Hedging Foreign-Currency Debt” by Fiona Law and Esther Fung, Aug. 28, 2015 (wsj.com)).

Share count

The jump in the number of shares in 2007 looks like it’s the result of converting preferred stock to common stock in connection with the IPO in late 2006.

A public offering in 2012 raised $167.9 million after expenses (see optics.org for various details). It might look unnecessary given the growth in cash since then, but IPG’s cash is probably held overseas, mostly, with only about 16% of sales in North America, while head office costs are in the US. From the 2014 10-K –

“At December 31, 2014 and 2013 , the cumulative unremitted earnings that are reinvested in non-U.S. subsidiaries are approximately $522,000 and $346,000 , respectively.”

That’s in thousands, and compares to 2014 figures of $522,150 for cash and $1,210,887 for total assets (in thousands).

IPG share count Q3 2015

IPG change in shares Q3 2015

DSO and days of inventory

I calculated trailing twelve month values for Q3 amounts in the next two charts, which means that Q4 2014 is included twice. The low value of R-squared for the Days Sales Outstanding trendline indicates that it fluctuates around an average, rather than having any trend (technically, it’s wrong to fit a trend line to a series which puts a third quarter result on the end of annual results). The DSO figure for the latest quarter includes the effect of incentives for early payment in China. While IPG have reduced the average days of inventory during the period, the trendline is not reliable for prediction. IPG hold sufficient stocks of parts to be reasonably sure that assembly can begin as soon as orders are received, and thorough testing before dispatch adds to the inventory.

IPG DSO and days inventory Q3 2015

The next chart adds lines for sales, net income and cash from operations. It isn’t surprising if cash from operations is affected by DSO and days of inventory, but I haven’t tested for it.

I made various tests which aren’t shown, with negative results, for relations between the change in sales, and DSO and days of inventory. The tests included the change in next year’s sales, and both the absolute DSO and days of inventory, and the percentage change. The maximum variation explained was 16.4% for the change in inventory and change in next year’s sales. I’d thought that maybe inventory was built up ahead of an expected sales increase (e.g. for product launches), but the figures for the period don’t support that. As well as explaining little of the variation, the trend line sloped the wrong way, as if more inventory predicted lower sales growth. I did not control for management statements, and if it’s ever stated that inventory has been increased in preparation for anticipated sales, my results won’t apply.

IPG DSO days inventory - sales income and CFO Q3 2015

Cash flow

My chart of cash from operations against cash used in investment shows good growth of free cash flow. Annual cash flow can be highly variable, and quarterly cash flow is even more variable. The latest jump in cash from operations includes the effect of higher collection in China, as a result of incentives to pay early, motivated by IPG wanting to reduce exposure to the Yuan. A fall back in cash from operations would not be surprising. I have not separated out the effect of changes in working capital (receivables, inventory etc.) which is usually the most variable component.

The investing cash flow includes cash used for acquisitions. There are two cases where IPG briefly held short term investments, with a cash inflow following a cash outflow. “Purchases of short-term investments” for $25.5 million in 2011 were followed by “Proceeds from short-term investments” in 2012 for the same amount. $6.95 million of short term investments (in marketable securities) made in 2007 were sold in 2008 for $5.45 million. Those outflows and inflows are not investments in the business, but the effect in the charts is mainly on the timing of investment. The overall picture regarding free cash flow is not affected, except that they happen to make investment look a bit more lumpy.

“Property, plant and equipment” generally dominates, with figures of $68.2 million and $53.0 million in 2012 and 2011 (i.e. bigger than the short term investment), $88.6 million and $70.9 million in 2014 and 2013, and $18.2, $18.6 and $14.0 million in Q3, Q2 and Q1 2015 (with Q3 and Q2 calculated). Capex is expected to hold steady, excluding acquisitions which tend to be opportunistic –

    “We’re running, what is it about, 7% to 7.5% of revenue this year. So even that represents a substantial amount of spending activity. I don’t expect to increase as a percentage of revenue in next year at all.” (transcript on Seeking Alpha)

IPG quarterly cash flows to Q3 2015

Balance sheet charts

Where I include Q3 2015, there has obviously only been nine months between the quarter’s figures and the end-of-year 2014 figures. Cash was boosted by about $160 million raised from new equity in 2012.

IPG assets Q3 2015

IPG assets per share Q3 2015

IPG assets per cent of total Q3 2015

IPG liabilities and equity Q3 2015

IPG liabilities and equity per share Q3 2015

IPG liabilities cash and current assets Q3 2015

(The “calculated liabilities” are the same as “Total liabilities” from 2011 onwards, when they are reported.)

IPG liabilities as percent of cash Q3 2015

Materials processing and Other applications

In the Prepared remarks the CEO said –

    “In addition, we continue to pursue projects in non-materials processing applications, such as advanced, medical and telecom, because they present significant opportunities for us as evidenced by their strong growth in Q3 when sales for non-materials processing increased by 168% year-over-year.”

The CFO was less upbeat, with –

    “As a reminder, advanced applications sales are typically large and uneven from quarter to quarter.”

I expect he meant all the “Other applications”, having said –

    “Sales to other markets, including advanced applications, telecom and medical applications,”

When “Other applications” decline for a few consecutive quarters, you only get the “typically large and uneven” comment. While it’s possible the segment will see stronger or more even growth, without further information my attitude is that I’ll believe it when I see it.

IPG materials processing and other Q3 2015


IPG results to Q1 2015 spread

The annual growth in the number of shares is not shown.

IPG balance sheet spread Q3 2015

IPG DSO days inventory - sales income and CFO - spread Q3 2015

IPG quarterly cash flow Q3 2015 spread

IPG sales breakdown 15Q3 spread

Thanks SA

With thanks to Seeking Alpha for their policy about quoting from transcripts, which can be found at the end of the transcript.

DISCLAIMER: Your investment is your responsibility. It is your responsibility to check all material facts before making an investment decision. All investments involve different degrees of risk. You should be aware of your risk tolerance level and financial situations at all times. Furthermore, you should read all transaction confirmations, monthly, and year-end statements. Read any and all prospectuses carefully before making any investment decisions. You are free at all times to accept or reject all investment recommendations made by the author of this blog. All Advice on this blog is subject to market risk and may result in the entire loss of the reader’s investment. Please understand that any losses are attributed to market forces beyond the control or prediction of the author. As you know, a recommendation, which you are free to accept or reject, is not a guarantee for the successful performance of an investment.

A low cost world

Disclosure: I’m long Cash America International Inc (CSH), General Electric Company (GE), Gilead Sciences, Inc. (GILD), IPG Photonics Corporation (IPGP), Main Street Capital Corporation (MAIN), SunEdison (SUNE), Winmark Corporation (WINA).


Human ingenuity is leading to low-cost energy, low-cost production and more efficient business, which could lead to increased discretionary income and higher discretionary spending, although the technology which brings the benefits could also reduce lower and middle incomes.

About this piece

I make connections across many fields, I don’t claim specialist knowledge in any of them and I doubt if anyone has specialist knowledge of many of them.

The title is not meant to imply that everything is low cost or soon will be, and anyone paying for dental treatment in the US is likely to see why.

For the same level of consumer confidence, more discretionary income means more discretionary spending. I don’t try to predict future consumer confidence.

Much of the piece is about innovation in a variety of fields, with little specifically about the cloud and biotech because they are well known. As well as lowering costs, innovation will produce profound changes, but that’s not the point of this article.

Factors against rising discretionary income

Further down I write about consumer debt, and about technology discplacing jobs. There are other risks and factors that affect discretionary income (and more), some of which I list here although any detail is beyond the scope of this article: war, natural disasters, European debt and Europe’s immigration situation, and anything else that would massively disrupt trade. Other factors are mentioned where they are relevant, for example the claim that fracking businesses operate as a Ponzi scheme is in the following section about fracking. I don’t list all the negative factors every time I say something is positive for discretionary income.


Cheap energy is good for discretionary income any place where energy consumption outweighs production. While the consumption roughly equals the production, cheaper energy is good for the world economy (the “oil shock” in the 1970s when OPEC was formed and exercised its cartel power did not make the world richer). There are doubts about the commercial viability of fracking (technically, “hydraulic-fracturing”), as in Shale Fracking Is a “Ponzi Scheme” (September 19, 2014, but with older quotes), and I haven’t found a fracker that has not racked up a load of debt. “Einhorn Slams Mother Frackers” Sep 10, 2015 (econmatters.com) has less detail about the fundamentals but it shows that the concern still exists. If the debt goes bad, I can’t say how widely the consequences would spread. See also “Wall Street’s Biggest Banks May Have To Make Good On $26 Billion In Oil Hedges” by Tyler Durden, 04/09/2015 (zerohedge.com) – the piece names a few banks, who were also lenders.

About recent bankruptcies and closures, see “Fracking Firms That Drove Oil Boom Struggle to Survive” by Alison Sider, Sept 23, 2015 (wsj.com). If a well generates cash, it’s worth something and will have a buyer in the event of bankruptcy. It’s the bankrupts that hit the news, but it’s the survivors that will shape the future of the industry. There are about 39 bankrupt solar power companies in the linked list, from 2009 to 2014. It didn’t stop the price of solar PV modules from falling or stop installation from rising.

It’s claimed that the technology is advancing rapidly, for example with smart drill bits. See “How Big Data Can Save the Shale Boom” Jun 03, 2015 (the-american-interest.com), and there’s more in “Saudi Arabia may go broke before the US oil industry buckles” by Ambrose Evans-Pritchard Aug 5, 2015 (telegraph.co.uk).

The piece “How Long Can the U.S. Oil Boom Last?” by Dennis Dimick, Dec 2014 (nationalgeographic.com) gives 5 to 8 years before shale oil runs out. President Obama said about gas, “We have a supply of natural gas that can last America nearly 100 years” in 2012. The U.S. Energy Information Administration used to underestimate the amount of gas that could be extracted, but seems to have over-compensated and been too optimistic in 2012. From “Natural gas: The fracking fallacy” by Mason Inman, December 3, 2014 (nature.com), a three year study at the University of Texas concluded gas production would peak in 2020 and then decline 50% by 2030.

The problem with the predictions is that the easiest gas is naturally extracted first. (The term “sweet spots” has been picked up by detractors, it implies a sharp division between resources easy to extract and resources hard to extract, which may be the case but I haven’t seen data for how sharp the division really is.) Next year, the gas won’t be quite as easy to extract, but technology and expertise will have improved. That describes the situation for any year, and it’s difficult to project which factor will win the race in the years to come. It’s also hard to know if or when the finance will dry up, with the availability and terms depending on perception and attitude as well as the facts, and on the decisions of ratings agencies. Finance has obviously dried up for some operators.

The arguments I’ve seen over profitability were polarized, and you can spin the same facts to say there’s rapidly advancing technology, or that fracking depends on uncertain future technological advances.

Some sources claim there’s a vast amount of shale oil and gas elsewhere in the world. If US shale runs out soon, either it will discourage extraction overseas, or America’s frackers will tour the world and there’ll be more total oil and gas extraction, during which technology will advance and expertise will develop, eventually allowing production in the US to be resumed.

Solar PV and energy storage

While there’s some doubt about the future of cheap oil & gas in the US, solar photovoltaic energy has been steadily getting cheaper. The industry has followed Swanson’s Law, which says that the price of solar modules drops 20% for every doubling of the total capacity ever produced. It’s a bit like Moore’s Law (which drives the falling price of computing power), except that Moore’s Law depends on time rather than cumulative production. Installation costs will be stickier.

I checked the US holdings in the solar ETF TAN’s top ten holdings and I give a very sketchy financial summary for the three most profitable ones. I only looked at the latest 10-K and 10-Q, and used Morningstar when needed for a three-years-ago figure.

First Solar Inc (FSLR) (SEC filings) has had positive Net income for two full years and for six months in 2015, and three full years of positive free cash flow but a negative six months operating cash flow in 2015. They have a strong balance sheet with more current assets than total liabilities. The cash flow can vary due to the timing of revenue recognition. They sell solar modules and the solid results are not representative of solar project companies. The stock price looks volatile on the ten year chart.

Advanced Energy Industries Inc (AEIS) (SEC filings) do power conversion products and are also not representative of solar project companies. They have consistently positive free cash flow numbers for three full years (if you don’t count acquisitions) and for six months in 2015, also current assets are more than total liabilities, but they lost so much market share in the solar inverter business in Q1 2015 that they decided to exit it, with layoffs expected.

SunPower Corp (SPWR) (SEC filings) has had two whole years of positive Net income but a negative six months in 2015. Cash from operations has been positive for three whole years, but free cash flow has generally been negative. The balance sheet seems reasonable, but is complicated by many items refering to footnote 1, about related-party balances for transactions made with Total. From the Q2 10-Q, in thousands, Total current assets of $2,172,113 are 1.95 times the Total current liabilities of $1,113,960, and are 80.3% of the Total liabilities of $2,706,213. Long term debt is small at $225,338, and the biggest long term liability is Convertible debt, net of current portion $693,938. Some of the debt is non-recourse, with no claim on the company beyond the assets used as collateral. SunPower are engaged in solar projects. From Morningstar’s company profile, you’d think SPWR maintained the solar system (a big ask).

Solar projects need finance for development, the official lifetime is about 20 years and they are likely to last longer, so high debt is expected when they are retained. In contrast, fracked wells deplete quickly so high debt seems more likely to be a problem. The equipment is not likely to last anything like twenty years (and at least some of it is now a lot cheaper, probably the older stuff). Debt has been incurred in both industries to finance fast growth (or to stay afloat, as alleged for fracking).

The ten year chart of the ETF TAN probably overstates the volatility of major US solar stocks because it includes the OTC stock Hanergy Energy, see “TAN Gave It’s Investors A Sunburn – Consider ICLN Instead” by Bruce Vanderveen, May 29, 2015 (seekingalpha.com) and the comments.

Casual Analyst on Seeking Alpha has questioned the value of retained projects (April 2014, seekingalpha.com), given the falling costs, doubting that the long term Power Purchase Agreements will hold. I disclosed at the top that I’m long SUNE, but it’s speculative and I’m not recommending it. What matters here is, I don’t see valuation or other issues stopping solar PV from growing and contributing to low energy costs. The implications of negative free cash flow, financing etc. can be argued over, as can the retained projects, but solar PV does not have shale’s depletion issue.

There is also high interest in energy storage, mainly battery technology, with Elon Musk (CEO of Tesla Motors and SpaceX, and chairman of SolarCity) betting on conventional Lithium-ion technology for his Gigafactory (and he’s betting against “over-hyped” breakthroughs). The Gigafactory should reduce costs through economies of scale.

At $3,000 to $7,140, Tesla’s Powerwall for domestic energy storage is currently not cost-effective compared to a net metering plan, but otherwise would usually break even on a “levelized cost of electricity” basis (which includes things like installation costs). That’s according to “Tesla Battery Economics: On the Path to Disruption” by Ramez Naam, April 30, 2015 (rameznaam.com) (probably based on a $3500 price). That’s without considering the benefit of keeping the lights on in a power outage. Tesla also makes the Powerpack for industrial customers. Mercedes-Benz are starting to sell batteries for the same purpose, for domestic and business use, see “Move over Tesla: Mercedes-Benz takes on Powerwall with a home battery of its own” by Ellie Zolfagharifard, June 10, 2015 (dailymail.co.uk). You get more power per up-front dollar from a home generator, but you have to pay for gas, and other factors complicate a comparison.

Ramez Naam also wrote “Why Energy Storage is About to Get Big – and Cheap” April 14, 2015 (rameznaam.com), where the author makes a case for expecting energy storage to soon be more cost effective than activating gas peaker power plants to satisfy peak demand (that doesn’t sound good for General Electric, who sell gas turbines).

About a year ago I heard a technologist on the radio complaining that nearly all the R&D in battery technology was incremental, i.e. likely to achieve it’s goal but with little chance of achieving a breakthrough. I’ve just googled “new battery technology” (without quotes) and got 17 relevant results dated 2015, on a page of 20 results. The variation includes quantum dots and solid state lithium-ion. Of course a quick search doesn’t measure the research budget.

Electric vehicles will be a lot more popular when you can charge them up with low cost solar power and go further with cheaper, lighter, more energy-dense batteries. Households can use the grid less or maybe not at all when they can have solar PV panels on the roof and store the energy. There are complications, such as climate and seasons, smog in some of the world’s cities, the relative merits of thermal (non-PV) solar, politics, and the effect on the grid, power utilities, and people who don’t own rooftops. The advantage of solar PV and local energy storage is bigger in poorer countries where the grid is less developed, and it can be leapfrogged for a system where energy generation and storage is close to energy consumption. A distributed system based on renewable energy avoids much of the capital investment needed for a grid, most of the power transmission and distribution losses (6% in the US), and the purchase and transportation of fuel. Obviously there are still capital, maintenance and replacement costs for the generation and storage of energy.

Even if fracking fails through a lack of profit, finance or resources, renewables (mainly solar PV) and battery technology will mean low cost energy, which is positive for discretionary income. Countries with the right kind of desert (sunshine, location, and not too many sand storms) could become energy producers. Saudi Arabia plans on exporting its sunshine, see “Saudi Arabia solar power exports ‘absolutely realistic’” by Ed King, May 31, 2015 (rtcc.org). Countries like Libya and Iraq could see their economies transformed if they can improve their politics, but that’s quite a big “if”, and there may be more chance of Spain or Greece making good use of their solar PV potential. There are many more countries with high insolation (sunshine), I’ll just mention Mexico where solar PV could power manufacturing for export to the US. While wide area transmission grids already span countries and continents, electricity transmission over long distances is not cost free, and security is likely to add to the cost in the Middle East. Wherever it works, there will be customers benefiting from cheaper power.

A bit off-topic, where ground water is scarce but humidity is high (Californian fog?), it may be possible for solar powered refrigeration to condense water out of the atmosphere. See this piece about a Dyson Award winning invention for filling a bicycle water bottle. Obviously that would need to be scaled up massively to have an economic impact, it might have to wait for solar power to get cheap enough, and water would have to be transported inland from the coast.

Electric vehicles and vertical integration

Electric vehicles have fewer moving parts, with savings in servicing and maintenance, see “Electric vehicles offer big SMR cost savings” by Andrew Ryan, August 12, 2015 (fleetnews.co.uk). Fewer parts could result in lower production costs than for gas burners if the battery cost can be brought down. Fewer parts also makes vertical integration easier. The quality-control downside of outsourcing is described in “Why Tesla’s Vertical Manufacturing Move Could Prove Essential To Its Success” by Jim Gorzelany, Feb 27, 2014 (forbes.com).


85% of the wolrd’s generating capacity is still steam powered, but advances are possible even in this old area. The title “Breakthrough in plant efficiency” (September 10, 2015, theengineer.co.uk) may be an exaggeration at this stage, but watching the behavior of vapor bubbles with high speed cameras has increased understanding of the boiling process, which may allow safe operation at higher temperatures and greater efficiency. The problem with putting more heat into the same boiler is that bubbles prevent the efficient transfer of heat. Too many bubbles leads to some very hot hotspots that damage metal in a “boiling crisis”. One conclusion is that surfaces in the boiler should be rough, but not as rough as suggested by previous research into heat disappation in electronic devices.

Commodities, currencies and China

The low price of commodities generally should also be positive for higher discretionary income. Commodities are priced in dollars and exchange rates affect prices (and vice versa). I’ve been saying since November 2014 that there’s a risk that $6 to $9 trillion of offshore dollar denominated debt could trigger a flight to the safety of the dollar (and to other currencies percieved as safe). One possibility is that the debtors are mostly businesses that earn dollars, so the currency of the debt matches the currency they earn, with little currency risk. Countries with currencies that fall faster than world prices won’t experience the “low cost world” of the title, if they import enough to create inflation.

The US has long been a net importer, allowing exporting countries to build up high dollar reserves, especially China with $3.8 tillion worth. Russia had high currency reserves, some of which they used to try to prop up the ruble, but the market had it’s way. However, Russia is highly dependent on oil and faced sanctions, making it different to other emerging economies. China could trash the dollar by liquidating part of its dollar reserves, but that would disrupt trade and reduce the value of its reserves. In contrast, a market driven flight of capital is not a plan based on the consequences. That’s why a flight to the dollar seems more likely than a flight from the dollar. It isn’t impossible for traders to get nervous about the US trade deficit and low reserves, but there’s no obvious reason for them to suddenly get excited over a situation that’s lasted for decades. That may change if China successfuly challenges or undermines the US dollar’s status as a reserve currency, in which case a lower dollar is likely to help the US trade balance. Wikipedia’s List of countries by foreign-exchange reserves puts the US at number 18 with $121 billion, after the UK, France and Italy.

Rising wages in China don’t favor low cost production and low cost imports from China, but a big effect on import costs seems unlikely. See “A tightening grip” March 14, 2015 (economist.com), it’s a little old but it’s about long term issues. The piece gives the double digit growth per year in manufacturing wage rates since 2001, and the rise in productivity which isn’t far behind. The concentration of various manufacturers in one area keeps the supply chains short (literally), with what I’ll call “economies of concentration”. It’s an excellent piece for anyone interested in China.

China is a big and growing market for IPG Photonics’ lasers, and there’s some risk that China will push the development of their own lasers. I mentioned it in “IPG Photonics cutting edge”, May 2015 (on Seeking Alpha, on blog site, find “Vertical integration in China”). I quote a claim that the Chinese government aims to achieve the level of vertical integration that IPG Photonics has. The laser sales are in line with China’s manufacturing becoming more sophisticated. That shouldn’t be surprising – the first Korean car’s body was made from oil drums (see “Meet the first ever Korean car” topgear.com), and their industry is rather more sophisticated now. I doubt if rising wages in Korea caused inflation in the countries they exported to. Although China is bigger, industries like clothing where low wages matter most will move to the low wage countries.

For the long term trend in commodities, see “COMMODITIES & THE 130+ YEAR BEAR MARKET” by Cullen Roche, 12/16/2010 (pragcap.com). The author used “euphoria” in describing commodity markets at the end of 2010, and warned that financial products wrapped around commodities were speculative. You need Flash for the images, if you don’t have it there’s a chart for non-oil commodities on “Commodity prices: Over a hundred years of booms and busts” by Andrew Powell, 28 April 2015 (voxeu.org) showing an overall decline and much boom and bust.

A more mixed price history is described here – “Commodity prices in the (very) long run Mar 12th 2013 (economist.com). Since 1900, the risers have been energy products, precious metals, and steel and its ‘ingredients’. Aluminum and zinc fell. The piece draws on a study of thirty commodities by David Jacks. There are charts and tables in the 39 page PDF “From Boom to Bust: A Typology of Real Commodity Prices in the Long Run” by David S. Jacks (Simon Fraser University and NBER), May 2014 (nber.org).

For innovation in mining, see “Rio Tinto talks up autonomous trucks, innovation cred” by Allie Coyne, Jan 13, 2015 (itnews.com.au), which describes how the miner operates mines from a remote center. A tire blowout on a huge mining truck is very expensive. Tires can be monitored with surface acoustic waves, allowing replacement before a blowout, without the inconvenience of wires or batteries on a rotating wheel or shaft. This link is mostly about checking for under-inflated tires in light vehicles – “Acoustic Wave Sensor Market worth $1,183.52 Million by 2020 (marketsandmarkets.com).

Recycling reduces the need for mining, and when a metal or other resource gets too expensive, substitutes can be found. Beyond occasional switching to palladium instead of platinum in catalytic convertors, I can’t think of good examples of price substitution, probably because high prices soon stimulate production. We have learned to live without asbestos, toxic metals like cobalt have been dropped from many products, and many soft plastics are now phthalate-free. Nanotechnology is giving us new materials like carbon nanotubes, graphene and metamaterials. There’s some effort to develop better construction materials, after years of little change, but the only good story I could find is from 2009 – “Better Materials Could Build a Green Construction Industry” by Mark Fischetti (scientificamerican.com). As suggested in a comment, building codes that don’t move with the times could be a bottleneck. I expect it will be a long time before we have to start mining asteroids, as in “Single asteroid worth £60 trillion if it was mined – as much as world earns in a year” (dailymail.co.uk). That much metal would crash prices and not sell for £60 trillion ($92 trillion).

One innovation in recycling is labels that come off PET plastic bottles easier, so they don’t contaminate the plastic during recycling. For a range of recycling machinery see edgeinnovate.com. A “trommal screen” is a rotating drum with holes that only small bits drop through, and the smallest bits are called “trommel fines”.

Soft commodities

The Jacks study concluded that soft (agricultural) commodities have been in long term decline since 1850. Beef was an exception, having gone up over the period. Given the limited area of fertile land, innovation must have enabled production to rise faster than the population. Major factors include the use of farm machinery instead of horses, oxen and manual labor, and the “green revolution” (pesticides, herbicides and crop breeds). New productivity drivers are arriving.

Satellite images have been available to farmers, sometimes for free. This PDF from fsa.usda.gov (April 2014) proves it for the US, but it’s a bit dull for non-farmers. The piece from digitalglobeblog.com about Africa and South Asia is more readable but has nothing surprising.

Now drones are available, although their use is restricted. With the right drone and an app, a survey can incorporate images using infra red radiation as well as the visible spectrum. The relatively ‘pinpoint’ information can be used to apply whatever’s needed to the patch that needs it, saving on insecticides, herbicides, fertilizer and water. Using drones for crop spraying avoids the cost of either employing a pilot or taking flying lessons, and avoiding the pilot’s weight saves on fuel and the material used in the drone, though opposition to permitting it is likely. For more detail see “Meet the New Drone That Could Be a Farmer’s Best Friend” by Rachel Rohr, January 21, 2014 (modernfarmer.com).

The 7 Best Agricultural Drones on the Market Today” by Andrew Amato, 2014 (dronelife.com) has the “Lancaster” drone from PrecisionHawk at number 3, with LIDAR (a sort of laser radar) among other features. There’ll be more drones on the farm as restrictions ease – “Why 2015 is the year agriculture drones take off” by Clay Dillow, May 18, 2015 (fortune.com).

My amateur guess is that Precision Agriculture (as it’s sometimes called) is at an early stage, and someone needs to integrate everything, bringing drones, artificial intelligence, agricultural equipment etc. together to make the whole operation smooth for farmers, who want to sit in the tractor and not spend time grappling with the IT (until someday the tractor doesn’t need them).

Instead of automating work in the fields, agriculture can be brought into the factory, as in “Japanese plant experts produce 10,000 lettuce heads a day in LED-lit indoor farm“. It’s in a former semiconductor factory, and looks like a mutant hybrid of that and a greenhouse. Apparently it’s not advanced enough for the Japanese, see “Fully Automated Lettuce Factory to Open in Japan” August 21, 2015 (wsj.com). In one sense it’s an inefficient use of energy, because if the electricity used to power the LED lights was generated by solar PV, there’s a huge energy loss between the sunlight falling on the panels and the light coming out of the LEDs, and the conversion to electricity and back to light can never be 100% efficient. On the other hand, the panels can capture frequencies (i.e. colors) that plants don’t use, and the LEDs can be designed for the frequencies they do use. Solar panels can be on non-fertile land or unused areas like rooftops. Solar PV converts energy more efficiently than photosynthesis (Solar PV, 10% to 20%, Photosynthetic efficiency 0.1% to 8%), but photosynthesis is present in both cases.

Fish farms are a fast-growing source of food, and aquaculture is probably more sustainable than using fishing fleets. Unfortunately the farms are plagued by sea lice, and pesticides from fish farms cause toxic pollution. One idea is to put a farm further out in the sea where currents are stronger and it’s harder for the infestation to spread. Most of this PDF – “Landscape/seascape capacity for aquaculture: Outer Hebrides pilot study” is dull reading if you aren’t a Hebridean fish farmer, but the paragraph with “up to three times the size of the average fish farm being located further out to sea in deeper water locations that have stronger currents, which helps reduce potential adverse environmental effects” proves I’m not making it up. See Wikipedia’s “Aquaculture of salmonids” for more info and an old chart showing the rapid growth of production.

Good long term returns in primary producer countries

There’s a table in “World stock markets: How historic returns have varied by country” February 19, 2014 (monevator.com) which shows that the annualized real return with dividends reinvested since 1900 for Australian and South African stocks is over 7%, beating US stocks where the return was 0.9% less. Both countries are primary producers, which suggests that either commodity stocks outperformed, or the sector was good for other businesses, contrary to the effect of resource exports making industry uncompetitive through a higher exchange rate (part of the ‘resource curse’). If commodities prices have been in long term decline, then the returns from Australia and South Africa suggest that commodities have experienced good deflation, with lower costs and higher ouput more than compensating for lower prices. You could say they were “emerging markets” in 1900, but not in the sense where low wages encourage manufacturing for export in labor intensive industries. In the absence of finding more data, there’s a complication – valuation affects total returns, so the high total return does not necessarily reflect the performance of the businesses. I cover the issue with hypothetical cases in “The effect of valuation on long term total return” September 20, 2015 (wordpress.com).

Inflationary emergencies

The green revolution increased crop yields at the expense of genetic diversity, creating vulnerability. It’s also been claimed to have reduced variety in the diet, risking malnutrition, for example with less millet being eaten in India.

The most popular banana in the 1950s, Gros Michel, is no longer available after being hit by Panama Disease. The replacement, Cavendish, would not be easy to replace because few of the varieties of banana survive shipping in good condition. I’d guess a banana crisis could be solved by genetic modification (GM).

Nearly all grape vines have European tops grafted onto American roots, due to the insect phylloxera which attacks the roots of the original European vines. See “DIY: Grafting Grapes by Maria Finn” October 11, 2012 (gardenista.com).

If anything happens to wheat, a GM fix won’t be easy due to its complex “hexaploid” genome, though I’m not saying a fix is impossible (if Monsanto did the fix, don’t expect the IP to be universally respected). See “Bread wheat’s large and complex genome is revealed“. The grafting solution used for grapes seems impractical for wheat. The vast “monoculture” wheat fields that allow efficient production can make the crop vulnerable to weeds, pests and disease, and monocropping (the same crop in the same field every year) increases the risk. Innovation might mitigate the problem, for example in tomato greenhouses they’ll release parasitic wasps if they have a whitefly problem.

Climate change or just long droughts also threaten the food supply.

The immediate financial result of food shortages is food price inflation. So far that’s only been a major problem in emerging economies, fixed by the passing of bad weather or by higher prices encouraging more production.

In general, I think high inflation is likely to be mostly the result of temporary shortages rather than endemic, unless central bankers go nuts. It wasn’t always independent central bankers who dominated economic policy, and it’s possible that governments could go crazy and cause high inflation.

Although I focused on agriculture, natural disasters could affect supply chains in other industries. That has happened for hardware depending on Japanese semiconductors after a quake (WSJ 2011), but if it caused any inflation I didn’t notice it.

Orbital Insight and AI

Orbital Insight use AI (artificial intelligence) to derive market sensitive information from satellite images. They cover retail, real estate, agriculture and commodities. They can measure the height of a building by the length of the shadow and the time of day, which allows them to see how construction is progessing. Apparantely the same technique allows them to see how full a big oil tank is. There are thousands of the tanks across the world and no-one collates the data on how full they are. Now Orbital Insight will sell you the information. It’s a young industry and not proven, but I expect the demand is there. Orbital Insight don’t say much on their site, they want customers to make contact.

See “A stunning new look from space at nature, North Korea and Chipotle” by Ana Swanson, July 23 (washingtonpost.com). It’s long but with plenty of images which are worth seeing. Other earth-monitoring firms are mentioned. It implies that the cost of a satellite is about 1/500 of what it used to be, but without a start date. Sometimes human ingenuity takes a rest – I googled “falling cost of satellites” (without quotes) and the results were like this – “Duck! Falling Satellite Arrives on Sunday”.

If Orbital Insight helps stock traders, then traders who can’t afford the service will be at a disadvantage and they need to know about it. I don’t expect long term investors to be affected. The service should also allow large enough businesses to operate more efficiently, where the data is relevant, contributing to the “low cost world”.

The automatic identification of objects in images is possible due to a recent approach in artificial intelligence called “deep learning”. The advance followed decades of disappointing progress, leaving Sci-Fi fans frustrated by the lack of killer robots. This – “Everything you need to know about deep learning and neural networks” by Margi Murphy, Aug 19, 2015 (techworld.com), is about as simple an explanation as you’re likely to see, with key terms explained at the bottom. Obviously the implications of deep learning go well beyond Orbital Insight’s service.

Efficient air travel

In my piece “Air Travel – an overview” (on Seeking Alpha, on blog site) I described “free routing”, the ability to put planes on more direct routes than currently. That includes steadier ascent and descent than today’s stepping up and down between pre-set heights, with level flight in between, which is not fuel-efficient. However it requires government investment and the US program has problems and political opposition. I haven’t seen such bad news about the European version. I also wrote about how satellite technology will identify the position of planes more accurately, allowing them to fly closer without compromising safety.

The satellite systems depend on cooperation, for example when Russian jets fly close to airliners in the Baltic, they don’t transmit ID or position information. Radar has the advantage that cooperation is not necessary, although military aircraft can be designed for stealth (the Russian jets in the Baltic show up on radar).

A new kind of radar can tell planes from wind turbines, and monitor drones. The UK firm Aveillant realized that instead of electronicaly filtering out excess information, digital technology meant it could all be processed (with chips from Nvidia). They call it “holographic radar” (and sometimes slip “3D” in front). A 40nm version was trialled in July.

In my Air Travel piece I covered tensions in Asia that could affect the future of air travel, and interrupt the progress driven by human ingenuity. Find “territorial disputes in Asia”.

The Internet of Things and GE’s Predix

Moore’s law continues to drive efficiencies, and now the Internet of Things (IoT) could start driving them. IoT is about everything from cars to thermostats communicating through the internet without human intervention, allowing data to be analyzed in the cloud and acted on. If that allows the failure of a machine part to be anticipated (for example), it can be replaced at a convenient time, rather than risk failure at an inconvenient time.

For RFID Pallet Tracking, a pallet fitted with an RFID (radio frequency ID device), GPS (global positioning system) and Bluetooth (low power, short range wireless digital communication), reports where it is and what’s on it (presumably with a list matching inventory to pallet ID). When a pallet load leaves a warehouse, the event is reported to the cloud within half a minute, where the information is available to the client or the client’s software. DHL and Cisco claim that IoT will be worth nearly $2 tillion to supply chains (through avoiding under stocking or over stocking, I suppose).

For an intro to IoT see “The Internet of Things Is Far Bigger Than Anyone Realizes” Part 1 and Part 2. For a big problem, see “The Internet of Things Is Wildly Insecure — And Often Unpatchable” (all on wired.com, 2014).

General Electric seem well positioned for their IoT platform becoming widely used, see “5 things you need to know about General Electric’s IoT cloud service: Is GE’s Predix the platform for industrial IOT?” by Matthew Finnegan, August 5, 2015 (computerworlduk.com), and “5 Reasons Why General Electric Has Much Bigger IoT Potential Than Intel Does” by Anchorite, Sep. 25, 2015 (seekingalpha.com) (I don’t mean to endorse the title). As a large industrial conglomerate, GE are in a position to “eat their own cooking”, and sell products ready to connect to the cloud. The platform’s claimed security will help adoption, and the actual security will be crucial for adoption in the long term. As I’m not a lawyer or security expert I have to assume there’s a risk of liability for big security failures, and my GE holding is small.

They aren’t doing it all themselves – see “Intel & Cisco Developing “Predix-Ready” Devices for the Industrial Internet” October 9, 2014 (genewsroom.com).

In “GE Predix Article : The Industrial Cloud is Here” September 10, 2015 (gereportsasean.com), under “What Can Efficiency Save Us?”, the first two paragraphs start with “Imagine”. There are no concrete examples of cost savings. I expect savings are likely (if the security holds up), but there’ll be a learning curve, and I can’t say when savings will become apparent. They’ll come earlier if Predix really improves safety. For anyone new to IoT, I don’t mean to imply that it all currently revolves around GE and Predix.

While Moore’s Law reduces the cost of computing and creates efficiency generally, increasing computing power enables medical advances, for example through modeling or easier gene-sequencing, and while I’m not saying that’s bad for the economy, if you don’t class medical spending as discretionary, expensive new treatements are not good for discretionary income.

US Medical inflation

CNBC highlight record medical inflation in April, which could be just a monthly blip. They also suggest that medical inflation could return to the double digit percentages that prevailed before the financial crisis and recession.

According to ycharts.com, the inflation rate has been less than half the long term average (which is under 6% pa) for about two years (on average, with some months higher than others).

An infographic from accounting firm PWC projects an over 6% rise in health spending in 2016. That’s about level with 2014 and 2015, after a decline from double digit growth in 2007 which is attributed to inflation (rather than more spending at constant prices).

The high cost of US healthcare may be indicated by this – “Americans Are Going to Juarez for Cheap Dental Care“, where the charges in Mexico are 60% to 70% lower. Labor and rent are cheaper in Mexico, while the US requirement for malpractice insurance and the longer time taken to train dentists are regulatory factors that affect the cost.

I expect that not all costs are likely to have downwards pressure from the factors I’ve mentioned, but that isn’t necessarily true for all medical costs. Maybe the cure for high prices is high prices. A long time ago I read a claim that the biggest problem in automating diagnosis is patient acceptance. The problem will diminish as medical costs rise, “AI doctors” improve (AI is artificial intelligence), and generations who grew up with smartphones are more used to software giving answers. See “AI found better than doctors at diagnosing, treating patients” Feb 12, 2013 (computerworld.com).

Smartphones can now be used to monitor vital signs and for diagnosis, see “The Future of Medicine Is in Your Smartphone” by ad health, January 19, 2015 (advertisinghealth.co.uk). I recommend finding “I thought I’d seen it all”. A smartphone and sensor can replace a sensor, dedicated computer, display and software, all with a big markup. The gross margins are high, see “Medical equipment and supplies gross margins” where only two out of fourteen margins in the linked list are under 50%, and two (for Medtronic and Zimmer Holdings) are over 70% (all based on the latest quarter). A 70% gross margin is the result of a 233% markup on cost.

In the news recently, Turing Pharmaceuticals raised the price of a HIV drug by 5,000%, prompting a tweet from Hillary Clinton which has been blamed for sending pharma stocks down. Her proposals are in “Hillary Clinton’s Drug Price Plan Would Make The Problem Worse — But That Doesn’t Mean We Should Do Nothing” by Avik Roy, Sept 22, 2015 (forbes.com). The proposal to cap the cost of prescriptions that insurers can pass on to patients, at $250 a month, probably excludes cures. If it didn’t, a single pill that cured a disease would cost a patient no more than $250 in total, while a regimen that lasted for the rest of a patient’s life could cost a patient $3,000 a year times the years of life left. A patient paying the maximum would have to pay much more for the inferior treatment. However, theguardian.com says the cap is for serious or chronic conditions. I expect that means serious AND chronic (because journalists don’t understand logic the way a programmer does), so the cap won’t apply to any condition that is not chronic (i.e. it won’t apply to cures). Googling “what is a chronic disease” confirms that it’s controllable but not curable. Another possible objection to the cap is that there are rare diseases where the R&D cost can’t be spread over as many patients, so the cost per patient will usually be higher.

The average press report has less factual info than the Forbes and Guardian links (assuming they’re right), for example “Clinton takes on ‘profiteering’ drug companies” September 23, 2015 (cnn.com), which does not mention shortening the patent life of new drugs, or the “serious or chronic” qualification to the cap. All the press reports look different to the ‘factsheet’ “Hillary Clinton’s Plan for Lowering Out-of-Pocket Health Care Costs” (hillaryclinton.com), for example she proposes to limit insurance premium increases. Hillary Clinton’s twitter feed is here, but there are many tweets, mostly on other topics. I’m not the first to say that from all the fuss, you’d think she was president.

US deflation stopped around 1950

While I see reasons for costs to fall, it’s a little hard to believe that consumer prices excluding energy will actually fall, at least generally and over several years, simply because that’s been rare (outside of Japan) in the recent era (fiat currencies, policies labelled “Keynesian”, quantitative easing). Wikipedia charts US inflation since about 1655, and there used to be as much deflation as inflation, while there’s only a tiny speck of deflation after 1950. Also, central banks seem to dislike deflation more than ever. Even so, the effect of solar panels on consumers’ own rooftops is likely to be significant by itself, with an average power bill of over $1,320 per year per residence for 2013 (find “Residential average monthly bill” on eia.gov for a PDF).

The many years where prices fell before 1950 did not stop the US from growing to become a superpower.

US price indexes recently

Ycharts give a five year view, which shows inflation dropping to around 0% in 2015. The Consumer Price Index showed negative inflation of -0.1% in August, after seasonal adjustment from +0.2% (from the Bureau of Labor Statistics). There’s also a table with annual inflation figures and monthly CPI figures on “usinflationcalculator.com“.

According to Wikipedia, the CPI and PCEPI inflation indexes are fairly close when averaged over several years, implying divergence when they are not averaged.

More technological advances

Additive manufacturing (which includes 3D printing) offers efficiencies, such as lighter aero engines, and it could reduce the part count in many manufactured items (even if the Star Trek replicator is still a long way off). A reduced parts count means shorter supply chains and less trucking, while rail is used for bulky commodity-like material and is not likely to be very affected. The points are covered in “2015 Commercial Transportation Trends” (strategyand.pwc.com).

When an app can summon a driverless cab, car ownership will become unnecessary for many people. Cars will still be owned for status or because some people just like to own and drive them, and sales of high-performance cars won’t be affected much. The level of ownership could depend on details like how clean the driverless cabs are kept. Like other disruptive innovation, there will be losers, in this case auto makers as there’ll be fewer cars with more use per car. Car park owners will be hit. Faced with falling sales, auto makers could design cheap and attractive “built to own” cars. I think there could be congestion if driverless cars are made to drive slowly in circles to avoid parking charges, but the author of “How Driverless Cars Could Turn Parking Lots into City Parks” believes the opposite, and ran a simulation which supports his view.

There will be an overall benefit through more income to spend on other things, but with temporary disruption to the economy, as happened for oil – “Itemizing The Oil Bust: 75,000 Layoffs And Counting“. Driverless taxis are a long way off, but meanwhile there’s Uber and car sharing companies (acquired by car rental companies) which make it easier to avoid car ownership, at least on average due to more mileage per car per day or more passengers per car.

There are smaller advances, for example IPG Photonics have developed a laser-based paint-stripping system for aircraft which saves labor and avoids using toxic chemicals. That’s just one example and there must be many advances I don’t know about.

For about two months worth of recent advances in bio-tech, see Scientific American’s page. I like “We Transformed Living Pig Cells into Tiny Lasers“. It might sound frivolous, but they can use the technique to uniquely tag a trillion cells, which should help research. Whether it will lead to expensive treatments or contribute to the ‘low cost world’, I can’t say.

One development I’m really not sure about is “Massive open online courses“. Some of the courses are free, and some courses have required text books (sometimes expensive and written by the instructor, it’s been claimed). Wikipedia say the completion rates are under 10%. While MOOCs avoid the expense of conventional eduction, I can’t say how effective they are or will be.

Technology or innovation?

I’ve used the term “technology” rather than “innovation” because innovation depends on technology and can be driven by it. For example the personal computer was one of the innovations produced by Moore’s Law – if you keep making smaller cheaper components, eventually someone will think of making smaller cheaper computers for personal use. I expect fans of disruptive innovation theory will disagree, and it’s not a point I feel strongly about.

Continuing technological advance

Without technology advancing we would still have a stone age economy. I’m not claiming the advance of technology is a new phenomenom, only that it will continue strongly, with a positive effect on discretionary income. Investors’ perception of the effect of technology will swing between under-appreciation and hype. Electrification, radio and prohibition were confidently expected to lead to a “new plateau of prosperity” in the late 1920s. The promised prosperity was real (though not due to prohibition), but it didn’t kick in until after the Wall Street Crash of 1929 and the Great Depression that followed. There’s some similarity to the Dotcom bubble that peaked in 2000, although there was more central bank intervention after the Dotcom bust (find “11 interest-rate cuts” on mises.org, which also lists intervention after previous crises). Recession/depression was avoided/postponed (depending on your point of view). The hype has come true, for example with old media businesses suffering while Apple is the second biggest company by profit (according to “What Are the Biggest Companies in the World?” by Matt DiLallo, Sep 10, 2015 (fool.com)). Currently there are tech stocks and other stocks on high valuations but I’m not seeing the hype or wild optimism that goes with a bubble.

Find where the benefit sticks

When ingenuity produces efficiency, where businesses don’t have a competitive advantage, the benefit will flow either to consumers or to a business in the chain which does have a competitive advantage. Those businesses where the benefit sticks are worth considering for investment, but finding them isn’t easy, for example chemicals companies use energy and raw materials but Eastman Chemical Co. (EMN) doesn’t have much pricing power, even after moving towards specialty chemicals for several years to get better margins (you can confirm the general lack of pricing power by checking the 25 instances of “price” in the Q2 2015 Earnings Call transcript). Another strategy is to invest in businesses likely to benefit from the increased discretionary income that would result from efficiencies flowing to consumers. There’s a little more about that near the end.

Sometimes an economic benefit sticks with land owners. Here’s a neat but unfortunate case from long ago in London. A politician had campaigned for tolls on footbridges over the river Thames to be abolished, because they were high relative to local wages. When he got his way, landlords put the rent up, leaving the workers no better off (find “Some years ago in London”). That was entirely predictable from an old-but-good theory by Ricardo. Local economic successes are likely to inflate rents and real estate, for example around Silicon Valley.

There’s a direct effect for solar PV and batteries – cost-effective batteries for domestic energy storage make solar modules more useful, which should make roofs more valuable, and therefore make buildings worth more. The “Housing Affordability Index (Composite)” (stlouisfed.org) is currently 151.2. Higher means more affordable, and 100 means a median income family has just enough income to qualify for a mortgage on a median-priced home.

There’s a tendency for speculation to force real estate prices up, setting them up for a crash. At the height of the Japanese bubble, some people valued the grounds of the Imperial Palace at more than all the real estate in California. That didn’t last.

Is deflation bad?

Inflation can usually be stopped when the political will exists, for example when Fed Chairman Paul Volcker got inflation down from 14.8% to under 3% in the 1980s. Some extreme cases are exceptions, such as the inflation of Confederate currency, when there was no monetary solution that could save the economy after the Union blockade of Southern ports. Japan has had decades of deflation while QE and low interest rates have not provided a solution. That probably explains why central bankers prefer to risk inflation rather than deflation if there’s any doubt about which to counteract. If Japan’s deflation is cured, the next worry will be that all the money-printing will cause hyperinflation, which is probably the most feared risk, although it’s not likely to last for decades.

Here’s a simple hypothetical case – if prices fall 10%, then even if income falls 5%, those with the income are about 5% better off in real terms (adjusted for inflation). If consumers use their greater real income to increase real spending, then consumer-facing businesses have more real revenue, although the effect on earnings depends on what happened to margins, and given the assumptions it would be harder for stocks to outperform cash. The greater real revenue should feed back up the supply chain. The fall in prices also increases the real value of net cash and net debt. Although that’s hypothetical, I’ll say that debtors’ pain is more newsworthy than the gain from holding cash, and a continual 10% deflation would be at least as bad for investment as a sustained 10% real interest rate – a high risk-free return is a high bar for investments to clear.

The falling price of computing power over decades has not devastated the IT hardware industry, although it hit the incumbent mainframe makers, many of which merged into Unisys which dwindled until it was kicked out of the S&P 500 index. The success of the non-incumbents is in contrast to the current commodities pain, with commodities giant Glencore PLC’s stock down about 75% from the price at its well-timed IPO in 2011. Differences include the cyclical nature of commodities, with companies over-investing in the good times.

Sometimes economists distinguish between monetary deflation and growth deflation. Monetary deflation is the bad sort and it follows a crisis. Hong Kong in the 1990s and Greece lately have had financial crises and not devalued their currencies – Greece can’t without leaving the Euro, and Hong Kong stuck to a dollar peg. The resulting deflation was and is painful. The Japanese bubble saw stocks and real estate rise. The Yen also rose, but as well as market forces there was an international agreement to let the dollar fall and the Yen rise. After crashing in 1990, deflation might have been worsened by the currency recovering too strongly, but it’s fairly complicated and I’ll refer you to Wikipedia.

Growth deflation is exemplified by the information technology industry, where you regularly get more computing power for about the same price. I would apply the term “growth deflation” to energy, as it’s fracking technology that’s driven lower oil and gas prices (although fracking benefitted from OPEC keeping the oil price high for decades), and for solar PV, the falling cost is due to technology and economies of scale, not monetary events. I see the recent collapse in non-oil commodities as an adjustment to over-supply, and would not call it growth or monetary deflation.

Wikipedia‘s deflation page is nearly all about monetary deflation, but they use the term “credit deflation”.

Hedge your bets

Suppose you find the “low cost world” argument credible and invest in companies which you believe will benefit from increased discretionary spending. Now suppose that the benefit of low cost energy, commodities and imports, and efficiencies generally, is not passed on to consumers. That means the benefit has been retained by businesses. The businesses most likely to keep the benefit are those where the low cost impacts and which have a competitive advantage (or “moat” when it’s enduring). If you can find such a stock at a fair price, it should work as a hedge, compensating if the benefit of low costs does not flow to consumers. Strong consumer brands could benefit from either increased discretionary spending or lower costs, and domestic exposure is preferable but may be hard to find or already priced in.

Demand, debt and excess reserves

In “2015 Credit Card Debt Study: Trends & Insights” by Odysseas Papadimitriou, Sep 9, 2015 (cardhub.com), the author warns of credit card debt reaching a tipping point which would be followed by high delinquencies. However, the chart of card debt per household doesn’t look too scary, with the debt slightly closer to the Q1 2011 low than to the 2008 high. Consumer debt is a concern but IMO the data is not strong evidence that overall demand will collapse or be constrained for a long time.

According to the St Louis Fed‘s chart, the ratio of US household debt to GDP has fallen from over 97.5% in 2009 to about 80% now, with the fall bottoming out in 2015. That’s good but it doesn’t necessarily mean the people in debt have seen their incomes grow faster than their debt, or grow at all.

If consumers borrow to spend, is it good for business, or bad because it’s unsustainable? The PDF “Debt overhang and deleveraging in the US household sector: gauging the impact on consumption” from the European Central Bank implies that “in the literature” there’s disagreement over whether more consumer debt leads to more or less consumption. I believe there’s less ambiguity about the effect of lower prices on discretionary income.

Default rates on student debt have doubled since 2011, mostly due to students at for-profit colleges, see “Default Spike in Student Debt Driven by Unconventional Borrowers” by Jeanna Smialek and Janet Lorin, September 10, 2015 (bloomberg.com). Student loans outstanding total over $1 trillion, with more than seven million debtors in default (Wikipedia).

It’s claimed the world is in the wrong part of The Global Credit Supercycle, and consumers have not reduced their debt. I’m not convinced by the chart showing that banks have low reserves if you remove the “transitory” excess reserves. It’s true that the excess reserves could be released if banks wanted to lend, but they are still reserves until that actually happens.

Excess reserves are reserves in excess of the reserve requirement set by the Fed. QE gave banks more money, but instead of increasing lending (and providing for the required reserve), it mostly went into a massive excess reserve. At around $2.6 trillion, the excess reserve is vastly bigger than the required reserve. It means that in principle banks could increase lending massively and quickly, causing inflation (or instability if the reserve requirement is too low). If that happened, in theory the Fed could counteract it by increasing the reserve requirement or raising the rate it pays on excess reserves. Many people don’t trust the Fed and therefore regard the excess reserves as a big problem. For more detail (and more concern) see “The Problem of Excess Reserves” by A Political Junkie, May 14, 2015 (viableopposition.blogspot.co.uk), or “Excess Reserves at the Fed: Lazy Money or Potential Hazard?” by Jim Allen, CFA, 20 February 2014 (blogs.cfainstitute.org). The comments under the second link cover complications which I left out. If you don’t understand all the technicalities, don’t worry, because the experts can’t always predict the effect of policies anyway. Some known effects were discovered accidentally, such as the effect of the Fed buying bonds, which is to increase excess reserves.

One comment says banks are constrained by the opportunities to lend, so the excess reserves are not likely to pour into lending. I agree with the first part, but the result depends on the prudence of borrowers and banks – when imprudent banks meet imprudent borrowers, the opportunities to lend have no obvious limit, as in the financial crisis of 2007-8. I’m not convinced that today’s excess reserves make the old problem much worse, but that could be a minority opinion. The next big financial bust could be bigger due to other factors, such as complicated but inadequate regulation, continued bail-outs by the Fed, and low interest rates for a long time.

Freight and sales

Freight indexes and other freight-related signs are looking bad, especially in Asia, see “Don’t Ignore the Big, Fat Transportation Warning Sign” by Tony Sagami, September 22, 2015 (mauldineconomics.com). One index not included is the U.S. Industrial Transportation Index, which has declined over the past year, but a longer view shows it’s off a peak at the end of 2014, which is not as bad as plunging to new lows. While the signs aren’t good for the short term, in the long run it’s the effect of lower costs on discretionary income versus the long term downward pressure on incomes (next section) that matters. It’s also possible that the U.S. Industrial Transportation Index will tick back up and the recent slide will look like a correction. The bad news about the cancellation of some Asian plane orders in Tony Sagami’s piece has since been offset by this – “Boeing wins $38 billion in orders, commitments from China“. However, an undisclosed amount of orders are not new, instead it’s claimed that buyers had not been found, and now they have. Boeing’s stock fell 1.5% on the news.

Ycharts show five years of US retail sales, with growth that slowed in the past year or two. The monthly figures are revised in later months. July’s double dose of disappointment was the weakness of the June numbers and the downwards revision of May, which had looked good in June. Then August brought joy with good figures for July and revisions-up for May and June. The revisions mean the figures are not reliable for the short term. See “June Retail Sales Drop Unexpectedly, May Sales Revised Lower” by Andrew Soergel (usnews.com) and “US retail sales rise in July, June revised higher” (ft.com).

When May’s retail sales figures came out, economist Joel Naroff thought consumers had been hanging on to the cash they saved from cheaper gasoline, and had started to spend it. That now looks like a premature call on the effect feeding through, and the “big thaw” explanation for May looks credible. See “Shoppers Splurge as Economy Heats Up” by Eric Morath (wsj.com).

The Bureau of Economic Analysis has various tables, including “Table 2.3.3. Real Personal Consumption Expenditures by Major Type of Product, Quantity Indexes” with ten quarters of stats broken down by sector. The total Personal consumption expenditures (PCE) index has moved up from 106.816 in Q1 2013 to 113.400 in Q2 2015, which I calculate is 2.7% pa.

Downward pressure on incomes

Possibly a bigger problem than debt is that some of the factors which reduce costs also keep wages down, reducing discretionary income as a result. See “Corporations Plan for Post-Middle-Class America” by Bernard Starr, 04/06/2012 (huffingtonpost.com). I found that one by searching for “hourglass economy”, a term that does not seem to have been used much since 2012. The thin hourglass waist translates to a small middle income population. For the “gig economy”, here’s a non-believer – “Proof of a ‘Gig Economy’ Revolution Is Hard to Find” by Josh Zumbrun and Anna Louie Sussman, July 26, 2015 (wsj.com). Maybe it’s just too soon to find evidence. In principle, anything that makes employment more flexible and helps the lowest qualified bidder to get the work (subject to the minimum wage), is good for efficiency but bad for wages and consumer confidence (at least immediately – there’s room for argument about the long term effect).

When middle-income jobs are lost, so is the income tax the employees previously paid. Some well paid work seems unlikely to disappear – top management, R&D staff, movie stars etc., so a big chunk of income tax shouldn’t vanish, but middle-income job losses would still be a problem for either government spending or the deficit. About the very high earners, Wikipedia claims nearly one and a half thousand people with income over a million dollars paid zero tax. If ordinary workers lose income while corporations and CEOs benefit from the savings, there’ll be experts looking into how to minimize the tax paid. Governments could see some savings on healthcare from the use of smartphones and (maybe, but not soon) the “AI doctors” I described earlier.

Zero-hour contracts give an employer control over the hours that employees work and are paid for. The author of “5 Reasons Why Zero-Hour Contracts Are the Future of Work” by Maite Baron, July 21, 2014 (entrepreneur.com), believes the contracts will spread from Europe to the US.

Workers compensation insurance shows how efficiency can lose to other factors, as the effect of increasing safety has been offset by higher awards of compensation. Companies have an incentive to avoid regular employment if doing so reduces the insurance expense. Employees without regular employment are likely to be less confident about spending even if their average wage is not lower. Companies that feel pushed to avoid regular employment could see either costs or benefits as a result.

You’ve probably heard of Thomas Piketty (Wikipedia). He argues that financial returns are greater than growth in GDP so inevitably the rich get richer while the poor get poorer. He’s provoked a vast amount of argument both against and in defense. One apparently simple argument against is that no-one can find a Vanderbilt millionaire, and there used to be 13 Rockefellers on the Forbes list of rich people and now there’s only one. IMO you don’t have to believe that inherited wealth persists and grows to see that checkout clerks who’s jobs are automated away are losing while CEOs’ compensation is rising, although I realize that simplifies a complicated issue, and if I was sure it would reduce discretionary consumption I would not have written so much about the factors that might increase it.

The rise of the machines

I’ll start with two old stories. A worker argued that mechanical excavators should be banned because each one put many laborers out of work. The boss said, think of all the jobs you’d create if instead of spades, everyone had to dig with teaspoons.

Henry Ford (allegedly) told a trade union official, “One day I’ll replace all the workers with machines, and they’ll never go on strike.”. The union official replied, “They won’t buy any cars either.”.

Mechanization and other innovations created prosperity rather than persistently high unemployment during the industrial age, as new jobs made up for the jobs that disappeared through mechanization or other labor efficiencies. I don’t claim that progress was painless, but workers in 1950 were better off than in 1850 or 1750.

The same does not necessarily hold in today’s information age. Government jobs may be safe, and the same may be true for academics, top management, R&D staff, movie stars etc., but outside of the safer areas the workforce can’t all do each others’ nails and hair while R&D work on the robotic salon.

This is an interview with the author of a recent book – “Rise of the Machines: The Future has Lots of Robots, Few Jobs for Humans“.

I don’t have much to say about current employment figures or about the minimum wage. I’m concerned with long term possibilities, and if a job would be automated away sooner at $15 per hour, it seems likely that it would be automated away later at $7.25 per hour.

I’ve used this before – “Starwood Introduces Robotic Butlers At Aloft Hotel In Cupertino” by Jordan Crook, Aug 13, 2014 (techcrunch.com)), and now I can add “New Japanese hotel has robot staff and no room keys” by Stu Robarts, July 22, 2015 (gizmag.com). The hotels demonstrate the technical possibility, and I expect they both have novelty value. Eventually, robot-staffed hotels will be cheaper, but it’s uncertain when. Many guests might be prepared to pay a premium for human service, but that’s also uncertain and likely to change over time.

This piece is mostly about the safest jobs – “The Robots Are Coming. Is Your Job Safe?” by Laura Entis (entrepreneur.com), but if your job isn’t mentioned you can try the BBC’s robo-risk search box.

Anyone who wants to invest in robot makers can see a list on “The Minimum-Wage Fight, Chinese Factories, and the Rise of Robots” by Tony Sagami, September 15, 2015 (mauldineconomics.com). I’ll guess the stocks won’t be cheap. The missing robot maker might be Fanuc.

Going into consumer mode

There’s a possibility related to increased discretionary income – developed countries going into consumer mode, rather like “Chimerica“, where China manufactured and exported and the US consumed, and the Great Moderation, characterized by low inflation and moderate business cycles, until the financial crisis around 2007. The links are to Wikipedia. The second piece mentions various factors that contributed to the Great Moderation, but not the role of cheap manufactured imports from China in keeping inflation low, and the recycling of China’s export earnings into US securities (and presumably into some European assets, so European customers didn’t run out of cash). Going into consumer mode depends on the effect of lower costs outweighing the effect of too much debt and the downward pressure on incomes I described above.

Trade imbalances can persist for a long time, creating instability. The last US trade surplus was in 1975. Since then, the dollar and the trade deficit declined until the 1990s when “hot money” that had flowed into emerging markets flowed back to the US in flights to safety, notably from Asian countries in the 1997 Asian Financial Crisis. Lower Asian currencies revived their exports and the US trade gap. (See “The History of the U.S. Balance of Trade” (about.com).) That could be partly repeating, with a downturn in Asia but not a close repeat of the crisis.

In simple terms, the financial crisis of 2007-8 can be described as the result of banks making bad loans and buying poor quality assets. Complex derivatives such as CDOs of CDOs boiled down to bad loans packaged into poor quality assets, with the poor quality obscured by the complexity. Explanations of the crisis can be pitched to blame banks or the government, depending on political preference. It’s possible to view the failure from an international trade angle. In economics there’s an accounting identity:

Savings – Investment = Exports – Imports

For simplicity I’ve ignored the effect of the government defict. By renaming the left and right sides of the identity it can be written as:

Private sector savings = Trade surplus

A trade deficit implies negative private sector savings, which means investment is funded by overall private sector debt. That’s fine so long as the debt is funding productive investment, but the pressure for new loans to sustain the trade deficit means that the investment may be unproductive, for example a home purchase with a mortgage that the borrower can’t repay. In other words, if the banks had not kept lending enough, then the trade deficit could not have been sustained. The level of lending necessary to sustain the trade deficit was independent of the opportunities to lend prudently, and quite possibly exceeded it.

I hope I’ve got that about right. Although the identity looks simple, the well known economist Paul Krugman has accused the Nobel prize winner Joe Stiglitz of getting it wrong, and at least one of them must have erred (see “More On The Exchange Rate And The Trade Balance” April 7, 2010 (krugman.blogs)). For more about the identity see “The Trade Balance” (arnoldkling.com). It starts with Y = C + I + G + X, where Y is GDP, C is consumption, I is investment, G is government savings (taxes – government spending), and X is the trade surplus.

Exporters also have problems. China is a major market for German exports, and concern about China having a “hard landing” shows in the DAX, the German stock index. When the financial crisis and recession hit the US, it was obviously going to affect the Chinese economy, and they reacted with stimulus, probably too much of it causing poor allocation of capital and corruption. (The Economist finds flaws in a widely reported estimate of $6.8 trillion wasted.)

A trade deficit on the current account (the normal trade of goods and services) has to be balanced by an inflow on the capital account. The inflow may be more sustainable when the owner as well as the capital moves, especially if the flight is from justice or injustice, which means that direct investment back into the country of origin would be risky. London has benefitted from incoming Russian oligarchs and their fortunes, although the term “benefit” would be disputed by people who don’t like the high house prices, which rose partly due to a spill-over effect from oligarchs buying expensive property. For the US, see “Fortunes vary for Chinese fugitives in US” May 18, 2015 (scmp.com).

An economist’s view

The economist John Mauldin wrote “Needed at the Fed: An Inverse Volcker” September 12, 2015 (mauldineconomics.com), which is mostly about “good deflation”. As the title suggests, he sees central bankers as a risk. I can recommend the article. There’s some overlap with this piece, and some of the same examples. I’ve aired my thoughts about the prospect of low costs in comments on Seeking Alpha, rather more briefly than here, before John Mauldin’s piece was published.

“Human ingenuity” is an old term. Warren Buffett has used it more than once, sometimes to explain his preference for investing in businesses rather than commodities. There’s nothing new about saying human ingenuity leads to progress, which includes the increased efficiency I’ve mostly concentrated on.

Previous writing on the issues

I posted some thoughts about lower costs leading to more discretionary income in a comment dated Sptember 5 on “Main Street Capital Survived Far Worse. Why Are You Scared Now?” by ColoradoCapitalManagement, Sep. 3, 2015 (seekingalpha.com) (find “About some macro factors”).

Back in April 2014 I commented “If energy gets cheaper and the savings aren’t pocketed by utilities, people will have more discretionary income”. It’s under the “questioned the value of retained projects” link above. You might have to click “Load all comments”.

I said something about the US economy going into consumer mode in a comment dated Aug 26 under “Is A Stronger U.S. Dollar Really Bad News For Emerging Markets? 3 Myths Debunked” (seekingalpha.com) (find “Chimerica”).

In April 2014 I tried writing about factors affecting solar PV like climate and seasons, the relative merits of thermal (non-PV) solar, politics, and the effect on the grid, power utilities, and people who don’t own rooftops. The result was so long and hard to organize I filed it under “Failed blogs” (here). It included the effect of cheap energy on discretionary income, and a theory (not mine) that oil producers would increase output in an attempt to get their oil reserves out of the ground and sold before the oil price dropped.


Main Street Capital is a Business Development Corporation (BDC), they finance small businesses and I believe they are likely to benefit from increased discretionary income, although many of the businesses they finance don’t sell direct to the consumer, and some are in oil & gas or have O&G exposure (find the “Consolidated Schedule Of Investments” in the latest 10-Q.). I expect the small businesses they finance to have high domestic exposure. One problem with MAIN is that their results benefit from issuing new shares at a premium, and if the premium disappears, so does the benefit from it.

Winmark Corporation run franchises specializing in “gently-used” goods, including Plato’s Closet (clothes) and “Once Upon A Child” (clothes, toys etc.). While they should benefit from increased domestic consumption, they aren’t highly levered to it, and when consumers have less spending power or less confidence they want a low price.

Cash America have a chain of pawn shops, and are concentrating on that after regulatory trouble over non-pawn consumer loans. They’ve said that business drops when the price of gasoline falls, and I’m not expecting the gas price to go up, instead I see the stock as a hedge because many stocks would be hit by a fall in discretionary spending.


A key question for anyone who cares about the long term is, will the workforce be better off as a result of lower costs, or will it be worse off as technology reduces the need for their labor. I don’t let the question dictate all my investments. MAIN, WINA and CSH collectively represent a weak bet on lower costs leading to higher discretionary spending, hedged for depressed incomes.

That’s all, thank you for reading this.

DISCLAIMER: Your investment is your responsibility. It is your responsibility to check all material facts before making an investment decision. All investments involve different degrees of risk. You should be aware of your risk tolerance level and financial situations at all times. Furthermore, you should read all transaction confirmations, monthly, and year-end statements. Read any and all prospectuses carefully before making any investment decisions. You are free at all times to accept or reject all investment recommendations made by the author of this blog. All Advice on this blog is subject to market risk and may result in the entire loss of the reader’s investment. Please understand that any losses are attributed to market forces beyond the control or prediction of the author. As you know, a recommendation, which you are free to accept or reject, is not a guarantee for the successful performance of an investment.

Air travel – an overview

Includes US stocks AVAV, BA, CAR, DIS, GE, HTZ, IRDM, JBLU, LMT, MAR, RTN.
Disclosure: I’m long General Electric Company (GE), AeroVironment, Inc. (AVAV).

I’ve listed the headings on a separate page – Headings in “Air travel – an overview”. It might be useful for navigating.


• Annual growth of 4.1% in the global number of air passengers carried is predicted from 2014 to 2034.

• A variety of trends and factors supports the growth, from more Chinese tourists to the “free routing” of airplanes, but a number of risks could affect it.

• Growth in air travel increases revenue in many industries, but due to competition there are few where the money sticks.

• Out of many companies I looked at, I believe only Disney combines pricing power with reasonable safety.

• I have not researched the stocks in depth, and I hope to learn that more of them are safe and have pricing power.

Businesses that should benefit from increased air travel

JetBlue Airways Corp (JBLU) offer air travel with low cost but with good service and amenities. At least they did, according to “A New Era Has Begun for JetBlue, and Travelers Will Hate It” by Brad Tuttle, Nov. 19, 2014 (time.com). According to a more recent article aimed at investors, the service and amenities are as good as ever, see “SWOT Analysis: JetBlue Airways Corporation” by Iason Dalavagas, June 29, 2015 (valueline.com). But – “JetBlue starts charging for all checked bags” by Carl Surran, SA News Editor, Jun 30 2015 (seekingalpha.com).

The policy of never cancelling flights backfired in 2007 when a snowstorm resulted in passengers waiting in a plane for 11 hours, only to have the flight cancelled. JetBlue are not likely to repeat the mistake, instead I see the incident as a general warning that marketing-friendly policies might be stuck to rigidly until experience teaches otherwise. There’s more company history on Wikipedia.

The Export-Import Bank has closed, meaning overseas airlines won’t get new planes subsidized by the U.S. government (find “Boeing’s Bank” below).

JetBlue look cheap on Morningstar with a forward P/E under 11 and Price/Cash flow under 7. Morningstar also show a high quality of fund ownership, giving five funds 5,5,5,4 and 0 stars out of a maximum of 5. Morningstar’s financial history shows that a double digit return on equity and on Invested Capital was only achieved in 2014 and “ttm”. The high leverage is the likely reason why double digit ROE is possible, given the single digit return on assets, which was below 2% from 2005 to 2012. The Operating Cash Flow has been much higher than operating income, but very high capex has resulted in erratic free cash flow, with big negative figures for 2005 to 2008. Although results have ticked up recently, I have not found a convincing reason why the future should follow the recent uptick rather than earlier financial history. If increased demand allowed JBLU to charge for all checked bags without the number of customers falling, sooner or later supply is likely to catch up with demand. My conclusion based on Morningstar’s figures and little research could be wrong, and the high quality fund owners could be right.

I have never researched airlines much because I believe they are likely to compete away any benefit to the industry. Warren Buffett has described himself as an “airoholic”, and said

    “Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.” (Berkshire Hathaway shareholders’ letter 2007)

Airports are more like unavoidable toll-gates. I found two companies domiciled in Spain with some airport ownership, I don’t like them much but I’ve written about them in “Aena SA – Spanish airport operator” and “Ferrovial SA – Spanish infrastructure company with an Airports division“. There are six other stocks in “Airport stocks list – none in the U.S.” (kitchensinkinvestor.wordpress.com).

Airbnb should benefit if air travel increases, but they are not likely to IPO on an attractive valuation, see “Airbnb raising $1 billion in new funding” by Sara Ashley O’Brien, June 18, 2015 (money.cnn.com). Uber might benefit (and might have an IPO) but they face restrictions, e.g. “Uber Drivers Are Getting Into Trouble at DC Airports” by Eric Hal Schwartz, 02/25/15 (streetwise.co). This – “Ride-hailing firm Uber faces big challenges in China” is about the raids, protests and competition in China, which has not deterred Uber from making China their top priority, pushing growth by paying drivers more than the customer pays. See also “Uber Lands Big Chinese Backer“.

The stock of hotel and lodging company Marriott International Inc (MAR) has been volatile, with a sharp drop from $75.31 in May 2006 to a low of $12.63 in March 2009, then rising to $74.80 on July 3, 2015 with a P/E of nearly 28. The low in 2009 was reached without much competition from Airbnb which was founded in 2008. To be interested I’d need to learn a good reason why there will be no repetition of the previous 83% drop (or even half that), or of the negative net income and free cash flow from 2005 to 2008, as they don’t seem to offer the growth that would compensate for the risk.

For Walt Disney Co (NYSE: DIS) (Morningstar, Seeking Alpha) to be relevant here, there would need to be more tourists attracted to theme parks by cheaper flights or quicker journeys than are encouraged to fly abroad as an alternative to visiting a theme park closer to home. I expect that to be true, especially if tourism from Asia expands. A long term share price chart shows a low of $15.83 in March 2009, another low of $30.16 in September 2011, and fast share price appreciation up to $114.97 as at July 3, 2015. The fast rise may suggest waiting for a dip.

Warren Buffett said good things about Disney’s moat in this PDF – “Buffett Lecture at the University of Florida School of Business October 15, 1998” (tilsonfunds.com), mostly about how Disney’s movies are a reliable choice for parents.

The company is excellent at merchandising, and the more characters and franchises they make money off, the more they can show in the parks (I needed this – “What’s the difference between Disneyland, Walt Disney World and the Magic Kingdom?“). The more movies are seen, the more tourists are attracted to the theme parks, and the more they make on rides. A good experience at Disneyland is likely to reinforce brand loyalty.

Apparently, not everyone that gets Disney wants Disney (BTW there was annoying junk on the page) – “Disney Targeted By Cable Bundle Critics In Campaign Urging More Consumer Choice On TV” by Christopher Zara, May 27 2015 (ibtimes.com). They want Disney in China – “World’s largest Disney Store is forced to close just 1 HOUR after grand opening as eager shoppers queue more than a mile to get inside” by Emily Chan and Edward Chow, May 21, 2015 (dailymail.co.uk).

I see aspects of the product as including emotion, experience, utility (keeping kids out of parents’ hair) and digitized information. The mix, the reputation and the cross-selling might be good enough for a moat for a long time, but I don’t see it as guaranteed. Way back when music came on vinyl, copyright must have seemed like good protection – if the product was consumed, profit would be made. It doesn’t work like that now. Disney have not gone the way of record labels, but I can’t be 100% certain that the model won’t be undermined, although that might just be because I don’t know enough or understand enough.

CAR and HTZ are mentioned next, and AVAV, BA, GE, LMT and IRDM are mentioned where they are relevant, further down.

Car rental

Car rental revenue is likely to increase if the number of enplaned passengers increases. Avis Budget Group, Inc. (CAR), Hertz Global Holdings Inc. (HTZ), and Enterprise Rent-A-Car dominate the car rental market and the airport segment in the US. However, when a rental company has an on-airport concession, it has to charge fees with names like Customer Facility Charge or Airport Access Fee and give them to the airport. There are also off-airport concessions, with some disadvantage through inconvenience or dependence on the airport. San Francisco International Airport lists “off-airport rental car shuttle” under “Ground Transportation” here, and they will charge the “ground transportation providers” that provide the service.

Industry consolidation has led to this – “Rental-Car Chains Bask in the Power of Higher Prices” by Justin Bachman, August 06, 2014 (bloomberg.com). Car rental companies compete to some extent with Uber, but some people might reject car ownership in favor of a mix of car-sharing, rental, Uber and conventional taxis.

Car-sharing is like rental but for only a few hours, in urban areas. Avis, Hertz and Enterprise all offer car-sharing, and synergies include demand at different times for rental and sharing. See “Avis to Buy Car-Sharing Service Zipcar” by John Kell, Jan 2, 2013 (wsj.com), and there’s a useful insight into how big rental companies profit on disposals, in “Explaining The Avis Takeover Of Zipcar” by Tim Worstall, 1/02/2013 (forbes.com). Generations used to streaming entertainment instead of buying and owning records or movies may be more open to the idea of car-sharing and other alternatives to ownership.

Hertz are at $17.25 (July 5, 2015) compared to a peak of $31.61, possibly due to this – “Hertz Global discloses another $30M in accounting errors” May 18 2015 (seekingalpha.com), and may be expensive with the forward PE around 20, although Morningstar gives a Price/cash flow ratio not much over two (as at July 3, 2015).

Avis may be a better investment, see “Avis Budget Group Set To Dominate U.S. Rental Cars” by Insider Monkey, May 28, 2015 (seekingalpha.com). Their US airport locations are listed here.

This – “Global Car Rental Market Poised to Hit US$ 106 Bn by 2020” (March 03, 2015) has a reasonable amount of info but they’re hoping you’ll want the full report. It’s positive about car rental at airports but it assumes the global economy will be good.

Given the fees airports collect from car rental, it’s possible that airports may be in a position to grab most of any benefit to car rental from increased enplanement, but that’s not a certainty. In fact it’s an interesting game theory problem – three rivals who compete but who also have the potential to benefit from cooperation are bidding to rent from not just one local monopolist, but a series of them. The ‘series’ makes the problem similar to a repeated game, and cooperation is higher in repeated games because there is more opportunity to punish cheaters. If an airport is squeezed too hard by the rental companies, it might be able to force rental customers to take a taxi or other transport to an off-airport car rental site, and make their money from the transport provider. In future, driverless taxis from Google could increase the competition to the advantage of airports, but domination by Google or further consolidation could follow. I have to stress I’m not accusing anyone of anything illegal, although collusion against airports would not excite much condemnation when the airports are using their monopoly position to add to the rental bill.

Imagine using an app to hail a driverless car. There are regulatory hurdles, but the possibility shows how the players need to be watchful and not let change pass them by. In contrast, there isn’t much car makers and dealerships can do about car sharing and driverless taxis eating into car ownership, and they’re on the wrong side of the discounts which big fleet buyers get, which may explain “Ford Jumps Into the Car-Sharing Pool With Pilot Program” Jun 24, 2015 (go.com).

I mentioned how consumers used to streaming instead of buying might see less need for ownership generally. The change in attitude is likely to spread from the US, but it’s hard to say how long it would take for the desirability of car ownership to fade in China. Maybe more people need to be able to afford cars before ownership becomes a less important aspiration.

The hospitality market

See this 36 page PDF from Ernst & Young – Global hospitality insights – Top thoughts for 2015. “Outbound investment from Asia” starts on page 10, the outbound hotel investment from Asia reached nearly 42% of the global total and it may continue to rise.

Asian tourists are not getting the service they want from western hotels, and that’s especially true for Chinese tourists – “The Services Chinese Tourists Want, But Aren’t Getting, From Western Hotels” by Eliza Ronalds-Hannon, Skift (skift.com). See also “The new chinese traveler is on the move and combines business and pleasure“, which mentions that Chinese tourists abroad have little interest in gambling.

Airport hotels could be next investor targets” by Jan Freitag, June 27 2014 (hotelnewsnow.com) – The chart of ADR (Average Daily Rate, the rental of occupied rooms) shows a rise, but it had not recovered to the peak reached in 2008.

PWC’s near-term forecast for annual growth in revenue per available room (RevPAR) in the U.S. is 7.0% for 2015 and 6.1% in 2016.

This piece about San Francisco, “2015 hospitality forecast: Hotel room shortfall puts damper on tourism boom” by Annie Sciacca, Jan 2, 2015 (bizjournals.com), shows that a shortage can develop which is good for hoteliers but bad for tourism. Investors are put off by low occupancy following the DotCom crash and the financial crisis. Normally I’d say that investors would get over it and invest, or over-invest, but awareness of Airbnb will be very high in San Francisco.

From this piece “PKF Hospitality Research Issues Consistent U.S. Lodging Forecast” June 4, 2015 (hotel-online.com) it’s possible to infer a long-run average growth in US RevPAR of 3.4% to 3.6%, with twice that predicted for 2016 and 2015.

PWC’s “Room for growth: European cities hotel forecast for 2015 and 2016” does not give overall figures for 2015 and 2016, but Dublin is expected to lead with a near 9% increase in RevPAR for 2015. The tone is generally positive, but with a warning that competition is hotting up, and Airbnb is mentioned. One factor is the use of robots and other advanced technology, partly to reduce costs (see “Starwood Introduces Robotic Butlers At Aloft Hotel In Cupertino” by Jordan Crook, Aug 13, 2014 (techcrunch.com)).

Consultants can get it wrong, at least in India – “Bankers reluctant to fund hoteliers as projections go awry” by Anita Bhoir & Varuni Khosla, Dec 10, 2014 (indiatimes.com).

I found no long term projections for the hospitality industry.

Tourist arrivals

UNWTO, the United Nations World Tourism Organisation, has published it’s free booklet “Tourism highlights, 2015 Edition” (PDF). UNWTO use a broad definition of tourists, saying 53% of international tourist arrivals were for leisure, compared to 14% for business (27% were in a broad category including visiting family, pilgramages etc.). They expect global tourist arrivals to grow 3.3% a year between 2010 and 2030, reaching 1.8 billion. I don’t know why a 2015 edition needs to start a projection from five years ago. For emerging markets, the projected growth is 4.4%, double the 2.2% projected for advanced economies. The global figure is lower than IATA’s projection for air passengers carried, although the periods are different as well as the item projected (IATA forecast 4.1% average annual growth from 2014 to 2034).

The 2.2% for arrivals in advanced economies is lower than I’d expect from the pieces I’ve linked to about tourism from China. UNWTO describe China as already being “the world’s top tourism source market”, and their spending abroad increased by 27% in 2014.

International tourist arrivals grew from 25 million in 1950 to 1,133 million in 2014, averaging 6.14% pa, but with major dips. In the same period, the receipts which destinations earned grew from $2 billion to $1,245 billion, averaging 10.58% pa. Assuming that’s not adjusted for inflation, I multiplied the 1950 figure for receipts by 9.80420 to get 19.6084, and the growth in real terms is 6.70% pa. (I used moneychimp and Calculator.net’s Inflation Calculator.)

The trend is for more overnight visitors to travel by air, with 54% by air for 2014, and 39% by road.

The interplay of hospitality, airlines and airports

Increased competition in hospitality is bad for margins in hospitality but good for airlines and airports.

Increased competition in airlines is bad for margins in airlines but good for hospitality and airports.

Other factors such as cheaper fuel costs or less fear of terrorism feed through to benefit all three industries.

It’s harder for airports to compete with each other, possibly because major cities already have airports and it’s not easy to get agreement or permission for another one.

Airport proximity

I found some airports close to each other on “What are the two closest airports to each other in the world?“. There are two airports only 1.7 miles apart in the Orkney Islands, Scotland – Westray Airport and Papa Westray Airport (the links are to Wikipedia). The scheduled flight time between them is two minutes, including taxiing. The two closest airports in the US might be Chignik Fisheries Airport and Chignik Lagoon Airport in Alaska. Those four airports are tiny. Zorg en Hoop Airport (small) and Johan Adolf Pengel International Airport (bigger) in Suriname, the smallest sovereign state in South America, are only 4.6 km apart.

While airports can be close, they don’t proliferate to the point where oversupply makes earnings crash, whereas in many capital-intensive industries, capacity increases until there’s a glut. Bankruptcy is still possible – Ciudad Real Central Airport in Madrid went bust after three years. It’s been alleged that the investors benefitted from construction contracts and never expected the airport to be viable. “14 of the world’s most amazing abandoned airports” has seven U.S. cases, not all civilian or international airports. One airport was attacked by a submarine.

An airport can be a natural monopoly, rather like “one town, one local newspaper” was for towns of the right size before the internet, but that isn’t a requirement for pricing power. London in the UK is served by three airports –

London airport ~ passengers in 2014 ~ distance from London center

Heathrow ~ 73.4 million ~ 14 miles
Gatwick ~ 38.1 million ~ 29.5 miles
London City ~ 3.6 million ~ 6.9 miles (smaller planes only)

Even with three airports, London is still so short of capacity that the mayor backed a proposal to put an airport on an estuary island, which would have cost £70 bn to £100 bn ($111 bn to $159 bn). The project, known as ‘Boris Island‘, has been rejected.

Other airport considerations

Privately owned airports are likely to be restricted by regulation which means they can’t increase landing fees to maximize their local monopolies (e.g. at Heathrow Airport near London). Disputes over landing fees in the U.S. seem to have been partly settled in 2008 – “Federal policy will let airports charge landing fees” 1/15/2008 (usatoday.com), with airports allowed to base fees on time and traffic volume. The piece expressed the hope that eastern airports close enough to be alternatives to each other would compete on landing charges.

When I looked for material about competition between US airports, all I found was this – “The Decline and Fall of the U.S. Airport” by Patrick Smith, January 24, 2015 (askthepilot.com). It’s mostly about long waits caused by the entry procedures for travelers arriving from overseas, even if they’re in transit to a third country. The same author wrote “Cockpit Confidential: Why International Business Travelers Avoid U.S. Airports” in May 28, 2013, opening with a survey by CNN that showed a substantial minority of business travellers to the US would not visit again or recommend visiting, due to the procedures. Monopolies have their limits, and for routes of equal distance travelers prefer to go the other direction around the globe to avoid a stop-off in the US. The list of taxes and fees collected by the government (e.g. “Federal Segment Fee”) indicates that airports don’t keep the monopoly benefits all to themselves, although US airports tend not to be privately owned so all the fees go to one level of government or another.

I’ve only checked reviews for two airports, and picked on Orlando. Orlando Airport scored five out of ten in customer reviews on airlinequality.com, with many complaints about immigration control. The smaller Orlando Sanford Airport scored seven out of ten.

It’s not hard to find material about competition between airports in Europe, but I didn’t find anything very good. This book promo – “Airport Competition: The European Experience” indicates that it’s a complex and subtle issue, and there must be substantial natural monopoly benefits to airports or there would be no need to review the debate in a book, or for a reviewer to asset that competition “can and does exist”.

Non aeronautical sources of revenue have been increasing, and increased traffic results in more revenue from parking, transport (ground based), rental cars, retail and duty-free, see “How Do Airports Generate Money? New Study Shows Nearly Half Comes From Non-Aeronautical Sources” by Christopher Harress, November 18, 2013 (ibtimes.com).

Air freight, FedEx and UPS

The same costs that affect passenger transport generally affect freight, with implications for FedEx Corporation (FDX) and United Parcel Service, Inc. (UPS). Two recent articles are – “FedEx: Down But Not Out” by Daniel Jones, Jun. 22, 2015 (seekingalpha.com) and “United Parcel Service – Will Deliver Returns As The Economy Expands” by Khen Elazar, Jun. 9, 2015 (seekingalpha.com). Investors need to decide if size gives the companies a moat, and if crowdsourced delivery is a threat, see “Amazon eyes crowdsourced delivery service” Jun 16 2015 (seekingalpha.com) and “I Just Tried Uber’s New Delivery Service ‘Rush’ And It Got Me My Package In 20 Minutes” by Alyson Shontell, Oct. 23, 2014 (businessinsider.com). (There’s also UberEATS.) Obviously it’s harder to crowdsource delivery over longer distances, across borders or over seas. The companies ought to benefit from the trend for shopping online.

I have not studied Fedex or UPS in any depth, but they have defined benefit pension schemes and I expect they have employed many staff over the years without very high productivity. Both companies now use “mark-to-market” for the accounting, and maybe I ought to be reassured by this piece – “Five years of mark-to-market pension expense reporting” by Bob Collie, June 10, 2015 (fiduciary-matters.russell.com), which explains that the method is transparent, at the cost of volatility.

Risks to the air travel industry

Air travel is vulnerable to economic downturns, war, terrorism, satellite failure, accidents, strikes, weather and volcanic ash clouds (see “Air travel disruption after the 2010 Eyjafjallajökull eruption“). See also “Cyber-Attack Warning: Could Hackers Bring Down a Plane?” (spiegel.de). This may have been Nato jamming during a military excercise, but they weren’t commenting – “Dozens of aircrafts briefly vanished from Europe radar” Fri, 13 Jun 2014 (sott.net, attributed to “Guardian”). Satellite failure is covered in links under “Satellite communications” below.

I have not said much about recent tragedies because I don’t think they have seriously affected the air travel industry generally. Malaysia Airlines were technically bankrupt and are relaunching, which is mentioned in “Malaysia Airlines plane makes Melbourne emergency landing” June 12, 2015 (bbc.co.uk).

The world economy faces a few problems. In emerging markets, there’s around $9 trillion of dollar-denominated debt which could trigger a ‘flight to safety’ of capital to the US, pushing up the US dollar and making the debt harder to repay. The risk was a theme of mine until I judged the media had caught up enough and the dollar had risen enough to highlight currency risks, although I learned I was way behind the economists Worth Wray and John Mauldin. See “Feeling green – Debt-ridden emerging markets are heading for a nasty dollar hangover” Mar 21st 2015 (economist.com).

IMO Greece is too small to have much effect on the European or world economy, but it may provide the spark for a big drop in stock or bond prices, given the generally high valuations, or it may spark a ‘flight to safety’. For example Greece owes Turkey over $30 billion (from “A Week of Unseen Things”, below). The Greek drama could make markets notice and start a flight of capital from Turkey and then maybe other emerging markets. I’m not saying that’s likely, I’m using it as an example of possibilities that are hard to predict. Some people believe that reduced liquidity in the bond markets increases the risk of a collapse. IMO liquidity is likely to dry up in any crash, as no-one wants to buy the ‘falling knife’. The Fed would probably react with Quantitative Easing, or if interest rates had been raised, lowering them again. With the EU now doing QE, they are likely to do more in extreme circumstances.

Also IMO, if Greece or any other country leaves the Euro (the European common currency), twenty years is long enough for recovery from the shock, and the common currency may do more harm to inefficient members than it benefits the exports of efficient members like Germany. Air travel does not seem to be very sensitive to the world economy, find “only a short-lived slowdown in the growth of passengers carried from 2007 to 2009” below.

Readers have probably heard enough about Russia, but maybe not so much about territorial disputes in Asia. This piece – “Territorial Disputes in Asia Show Sovereignty Still Matters” by Francesco Mancini, July 8, 2013 (theglobalobservatory.org), starts with a fisherman who was killed by Philippine coastguards, leading to outrage in Taiwan, sanctions, and cyber attacks in both directions. The scale is far below Russia’s invasion of parts of Georgia and Ukraine, but it may show a tendency for national pride to cause outrage and a refusal to back down or apologise. I’d guess that escalation is possible but unlikely.

This – “Dormant and Unresolved Border, Land, and Maritime Disputes in Southeast Asia: a New Threat For ASEAN?” is a fairly dull list of academic research abstracts, with only one conflict with casualties (Thailand vs Cambodia), but it claims a “multitude” of dormant and unresolved disputes that could threaten stability. That isn’t reflected at all in Wikipedia’s List of territorial disputes.

China has extensive claims in the South China Sea based on maps with dashed lines, the earliest of which was published in 1947 according to Wikipedia. There are recent articles relevant to the claims on nine-dashed-line (thediplomat.com), and see “Images show Chinese airstrip on man-made Spratly island nearly finished” by Dean Yates, Thu Jul 2, 2015 (reuters.com).

The Japanese occupation of Korea is still a live issue, e.g. “Korean sexual slavery victim to hold protest rally in front of Japan’s embassy in Washington” 2015-06-27, even though South Korea and Japan are both threatened by North Korea. About sites from Japan’s industrial revoluation – “Korea objects to heritage status for Japan’s World War II ‘slave labour’ sites – by Donald Kirk” The Independent, May 26, 2015 (republicofmining.com). Japan and Korea won’t fight a war over their differences, but old issues between East Asian countries could make an effective alliance against Chinese ambitions harder to achieve, or harder to achieve soon enough, which could encourage China to pursue claims more aggressively.

In “Chinese Nationalism: The CCP’s ‘Double-Edged Sword’” by Jessica Chen Weiss, November 25, 2014 (thediplomat.com), the author/interviewee argues that Chinese demonstrations of nationalist anger are genuine and not the result of party manipulation. Japan is a popular target. When Vietnamese protests over an oil rig led to the killing of Chinese workers, China did what it could to keep its population calm, because their strategic objective had been achieved and there was no point in inflaming the losers.

Probably no-one wants a war, given the economic consequences and the danger of escalation to nuclear levels, and I don’t mean to imply that a major war in the region is likely.

Europe isn’t free of internal tension, for example “Serbia asks Russia to veto UN resolution that calls Srebrenica massacre ‘genocide’” July 4, 2015 (globalnews.ca). There’s tension over Greek debt, with occasional reminders about the forgiveness of Germany’s debt, see “Greece and Spain helped postwar Germany recover. Spot the difference” by Nick Dearden). Even so, for most of the countries a border incident or military conflict between them is about as unthinkable as for the US and Canada.

The United States vastly outspends other countries on defense. From Wikipedia, for 2013, in billions –

US $640.2
China $188.4
Russia $87.8

Even so, with threats, trouble or tension around Russia, the Middle East, and East Asia, the US could become overstretched.

air passengers carried after 9-11 terrorism

Air passengers 1990 to 2013

The chart is based on figures taken from or derived from a table provided by the World Bank. I calculated “North America” by adding the figures for the USA, Mexico and Canada, and according to Wikipedia I missed out a lot of countries (see “Spreadsheets” below).

air passengers carried - short
Air passengers 2014 to 2034

The data used for the next chart was taken from the press release “New IATA Passenger Forecast Reveals Fast-Growing Markets of the Future“. IATA forecasts 4.1% average annual growth in air passengers carried globally from 2014 to 2034.

There are problems with the data. It’s imprecise, for example the figure of 2.9 billion passengers for Asia-Pacific in 2034 only gives one decimal place, and corresponds to a range between 2,850 million and 2,950 million (minus one). The full report is likely to be more precise, but it costs $2,500. The problem is compounded because in most cases I had to subtract the projected increase to get the 2014 figure, and for Europe I had to work from only the increase and the annual growth rate. Using imprecise figures in calculations leads to even less precision. The categories don’t look the same as for the historic data in the previous chart, with “Asia-Pacific” instead of “East Asia & Pacific”, “Middle East” instead of “Middle East and North Africa”, and “UAE plus Africa” instead of “Sub-Saharan Africa”. It’s not surprising that the chart is not continuous with the chart up to 2013, but the implied drop in the total from 3,973 million to 3,167 million is 20.3% and may be due to a major difference in methodology.

The figures in the forecast are for flights “to, from and within”, although that’s only stated for Asia-Pacific. It means a flight from one region to another will be counted in both regions (and presumably a return journey will be counted again). Passengers flying from the US to China can be US travellers to China or Chinese tourists returning home. It doesn’t make much difference to plane makers, airports etc but it makes a big difference to businesses in hospitality, attractions, car rental etc., if they are not equally represented in both countries. Increasing Chinese air travel is at least consistent with the “surge in tourists and other visitors to the US” (from China) which I mention later.

IATA is the trade association for the world’s airlines. While readers should consider that IATA may not be impartial, the forecast was made with a subsidiary of Oxford Economics, who claim “Oxford Economics continues to outperform other global forecasters, August 2013“. The reliability of almost any twenty-year forecast is doubtful. The inputs from demographics are probably more reliable than the assumptions about economic growth, which may have been optimistic to get the forecasted 4.1% global growth in air passengers carried. However, my charts show only a short-lived slowdown in the growth of passengers carried from 2007 to 2009, while the financial crisis was severe, and recovery from the recession that followed was slow. There has been no shortage of bad news from Europe since then, also concern about China’s debt and slowing growth, and demand for commodities cooled, affecting many emerging economies, yet the passengers kept flying in increasing numbers since 2009.

I applied a smooth growth rate to get from the 2014 figures I calculated to the 2034 figures.

There is more information in the press release. Under “Explanation of demand drivers” there are paragraphs for “Living standards”, “Population and demographics” (population decline in Japan, Russia, and Ukraine, rapid growth in Africa), and “Price and availability”. There’s no mention of terrorism, war, or the kind of sub-war conflict that could affect flights. Although a reduction in the real cost of air travel is forecast at around 1% to 1.5% pa, it’s my impression that they have probably not fully factored in the potential of “free routing” aircraft across the skies (see below), but find “Price and availability” in the release and see what you think. It’s unlikely they’ve factored in any benefit from holographic radar (see below). There’s also this PDF from the FAA – “FAA Aerospace Forecast Fiscal Years 2014 – 2034“.

air passengers carried 2014 to 2034
Air passengers 1970 to 2034, log chart

A slowdown from 4% growth to 3% growth might not be clear in a normal chart, but when the logarithm is charted it would show up more clearly as the gradient becoming less steep. The top half of the chart shows the discontinuity between the World Bank’s figures which end at 2013, and IATA’s projections which start at 2014. In the bottom half I shifted IATA’s lines up so they joined with the World Bank’s lines. Because I used base 10 (for the logs), an increase of 1.0 represents growth by a factor of ten, e.g. from 7.0 to 8.0 (7.0 means 10,000,000 – with 7 zeros, and 8.0 means 100,000,000 – with 8 zeros). The scale is marked in steps of 0.2, and each increase of 0.2 in the log represents an increase of 58.5% in air passengers carried.

air passengers carried 1970 to 2034 - log
Air passengers, stacked chart

Because the regional figures are for flights “to, from and within” the regions, there will be double counting in the totals represented by the heights of the stacks. The implied totals are good for the percentages in the charts. In other words, without the double counting in the total, I would expect the percentages for each region to add to more than 100%. At least, that’s the theory. My “stacked” total for 2034 is 7.0 billion, but IATA project a total of 7.3 billion for 2034. The difference could be due to the problems with the data I mentioned above, in particular the rounding error of figures to only one decimal place, compounded by further calculation. I have not included every warning about the data in every chart.

air passengers carried 1970 to 2034 - stacked
Air passengers, China, US, India, UK and Brazil

I forgot to say the scale is in millions.

top countries air passengers 1970 to 2034
IATA’s growth figures and the 2034 top 9

Extracted from their press release, average annual growth in passenger flights 2014 to 2034 (to, from and within regions and countries) –

    Total 4.1%
    China 5.5%
    Asia Pacific 4.9%
    Middle East 4.9%
    Africa 4.7%
    Latin America 4.7%
    North America 3.3%
    US 3.2%
    Europe 2.7%
    Japan 1.3%

Predicted top 9 countries for flights in 2034 (by traffic to, from and within) and movement from 2014

    1 China – up from 2
    2 United States – down from 1
    3 India – up from 9
    4 United Kingdom – down from 3
    5 Brazil – up from 10
    6 Indonesia – new in the list
    7 Spain – down from 6
    8 Germany – down from 5
    9 Japan – down from 4

Trends and factors affecting air travel and transport

• Tourism and travel from Asia
• The low oil price and other cost reductions
• Free routing

In more detail –

Tourism and travel from Asia

Increased tourism and travel from Asia and especially China is likely if economic growth continues and discretionary income increases as a result. China’s rebalancing from an investment-led economy towards consumption and the private sector should favor growth, spending and travel in the long term, but the huge amount of debt in China could cuase problems.

The Top Chinese Travel Trends to Watch for in 2015” by Rafat Ali, Skift, Dec 24, 2014, (skift.com). One prediction is a surge in tourists and other visitors to the US.

I found no evidence of a large number of Chinese tourists heading to Las Vegas. My searches turned up “$4 billion Chinese-themed resort coming to Vegas” and Vegas casino operators with casinos in Macau. Macau (Google map) is a region near Hong Kong with an area of 11.6 sq miles and high population density, which could limit the scope for casinos to expand. For comparison Las Vegas is 135.82 sq miles and the metropolitan area is 83 sq miles.

This piece makes five optimistic predictions – “What will 2015 Bring for Chinese Tourism in the United States?” by Avery Booker, 06 January 2015 (chinaluxuryadvisors.com), about the US vs Europe, investment, mobile devices, a mobile ‘chat’ app, and individual tourists.

Value Retail are a private company but they have an interesting business model, selling discounted luxury goods through nine shopping villages in Europe and one in China. They sell to shoppers who want discounted luxury brands and who demand a luxury environment that does not feel like a dumping ground for surplus stock. Shoppers who have travelled thousands of miles particularly value the experience as much as the discount (even if they fund the trip by selling purchases back in China). Brands occupy space in the villages and pay a percentage of sales to Value Retail. The model minimizes the damage that discounting can do to brand image. They followed the principles and predictions of retail guru Marvin Traub, which are in this PDF from 2008.

It looks like Value Retail know how to exploit China’s retail tourism – “Value Retail promotes shopping tourism with Chinese airline partnership” by Staff reports, June 5, 2015 (luxurydaily.com) – it’s a kind of mutual promotion, or cross-selling between different companies. See also “CEO Talk | Scott Malkin, Chairman, Value Retail” June 5, 2013 (businessoffashion.com), which says quite a lot about Chinese shoppers.

China’s retail tourism could be hit by this – “China cuts import taxes to boost consumer demand” 25 May 2015 (bbc.co.uk). Unilateral tariff cuts might seem un-Chinese, but outbound retail tourism costs their economy more than importing the goods, and it’s possible that more tax will be collected in total, even with lower tariffs. The effect will be good for luxury goods makers, and bad for air travel.

Not too worried – “Another Glimpse Into China’s Debt, And Where It’s Heading” by Kenneth Rapoza, 5/29/2015 (forbes.com)

More worried, but about financial zombification rather than a crisis – “The great hole of China” Oct 18, 2014 (economist.com)

There’s an ebook with the snappy title “A Great Leap Forward? Making Sense of China’s Cooling Credit Boom, Technological Transformation, High Stakes Rebalancing, Geopolitical Rise, & Reserve Currency Dream”, where the contributors are mostly pessimistic but not all of them (on Amazon). Here’s a long synopsis by co-editor John Mauldin.

The bank HSBC are considering moving their domicile from the UK to Asia, possibly to Hong Kong. If they aren’t bluffing to influence UK policy, they are likely to have a positive outlook regarding Asia, and with their large business in the region they should be well placed to judge the prospects. The Guardian’s article about it only considers the politics and regulation in the UK.

Because stock prices could conceivably have a wealth-effect on spending, I’ve linked to “A Week of Unseen Things” by John Mauldin, July 4, 2015 (mauldineconomics.com), find “Shanghai Falls to Earth” in it. More Chinese are piling into stocks but as momentum traders rather than value investors, and the likely result over time is stocks going higher but with volatility and sharp pullbacks. Previously I heard about Chinese investors spending less so they could buy into the bubble, which is the opposite of the usual supposed wealth effect, although I can’t substantiate the story. You can get a chart of the Shanghai Composite Index from 1996 on the link by choosing “all data”. It shows that the peak in 2007 has not been surpassed (as at June 30, 2015).

Chinese stock valuations are highly uneven, there’s room for quality stocks to go up while the crazy valuations fall, and as investors take advantage of liberalisation, Hong Kong stocks could rise as Shanghai stocks fall.
See “Opinion: China’s Stock Connect: More boom and bust?” by Craig Stephen, Apr 12, 2015 (marketwatch.com).

A high dollar is not good for incoming tourism. One point to consider is that dollar strength tends to go with low commodity prices, including oil.

One of China’s aims is to make the Remnimbi a reserve currency, challenging the US dollar, but the aim might not be compatible with the growth they want. Reserve currency status seems likely to make the remnimbi higher than otherwise, by increasing demand for the currency. A high remnimbi makes tourism from China more affordable.

It’s been projected that half of the world’s cruise passengers will be from China by 2020, see “CSSC joins race to build China’s first cruise ship” (seatrade-cruise.com). In the US, 49% of cruise passengers were aged 50 or older (in 2011), but Chinese cruises are expected to attract younger passengers and families.

Using rough historic approximations, assuming 300 ocean-going cruise ships averaging 2,000 passengers each, guessing 10 days per cruise (so about 37 cruises per ship per year), I get 300 * 2,000 * 37 = 22,200,000 passengers per year, compared to 3,972,988,179 for air travel in 2013 (from summing the World Bank’s table). That’s about 22 million cruise passengers and 3,973 million air passengers, or 181 air passengers for every cruise passenger. I don’t expect cruise holidays to have much effect on air travel.

The low oil price and other cost reductions

The benefit of the lower oil price is passed on to passengers through competition by airlines, and the low oil price could lead to increased discretionary income and more travel (although some employment is favored by a high oil price). Technology such as lighter, stronger materials and more efficient engines (helped by 3D printing) increases the fuel efficiency of aircraft (although the planes and engines aren’t cheap).

In the U.S., the cost of extracting unconventional hydrocarbons is still coming down. Efficiency has been increasing with experience, which is one of the features of extraction from shale that makes it more like manufacturing than conventional extraction. The next link explains it better than I’ve ever seen before – “The Shale Boom Shifts Into Higher Gear” by Donald L. Luskin and Michael Warren, May 31, 2015 (wsj.com). The fact that shale oil is front-loaded (i.e. a well peaks early) has been seized on by writers who call shale production a “Ponzi scheme”, which seems like a loaded term to apply to unconventional production, although the financing may be another matter.

There is still controversy over how much can be extracted, but there’s also the possibility of applying the techniques in other parts of the world. In “Govt Report Says Shale Oil Will Run Out Soon, Start Drilling Offshore” Mar 26, 2015 (marcellusdrilling.com), the government’s pessimistic view is disputed. Also, “Shale oil and shale gas resources are globally abundant” January 2, 2014 (eia.gov).

The cost or benefit to a company of short term movements in the oil price depends on how much of the impact is hedged.

There’s been much talk of growing algae to make aviation fuel, but Solena Fuels and Velocys plc (VLS.L) (I’m long VLS.L) are pioneering a “biomass-to-liquids” process, see “GreenSky London site selection” about the production of aviation bio-fuel scheduled for 2017. Solena claims to sell fuel at spot prices with no subsidies. The customer British Airways has committed to buy at long term market competitive rates, which may be lower than the suppliers initially expected. It’s possible that the technology could become cheaper once it is established. The partnership lags behind China’s Sinopec and Hainan Airlines – “China commercial flight uses Sinopec bio-jet fuel” 25 Mar 2015 (argusmedia.com).

Sorry, Everyone, Making Fuel Out of Seawater Isn’t Gonna Save Humanity” by Martin Robbins, April 19, 2014 (vice.com) is about the mis-reporting of the Navy’s demonstration of a “fuel from water” process. The author is right that the media is hopeless at reporting such stories accurately, and right in pointing out that the methane by-product is a potent greenhouse gas. There’s actually nothing surprising about being able to turn one form of energy into another (except for ambient temperature heat, see “Maxwell’s Demon” for the physics), and in this case electrical energy was turned into chemical energy – the energy unlocked when fuel is burned. The conversion efficiency matters (and the by-products), but the volume of water required is probably not very important because no-one cares much about the water produced when fuel is burned. If a suitable region has surplus electric power for some periods, it may be economic to use it to make fuel, depending on various factors.

The cost of solar photovoltaic energy is falling, roughly in line with Swanson’s Law, a kind of solar power version of Moore’s law. The installation costs are likely to be stickier. To compete more broadly with oil, intermittent renewables need more affordable energy storage, which might still be some way off, and batteries with higher energy density would help the take-up of electric vehicles.

If you google “solid state lithium ion batteries” (without the quotes), you’ll find big names like Google and Toyota in the research race. I’ve also read that Apple are in the race and General Motors have had some kind of involvement. The U.S. startup Sakti3 seemed to emerge from nowhere, and U.K. appliance-maker Dyson have invested $15 million in them. (I’m long Ilika plc (IKA.L), who are in the race.) Tesla, the high-end electric car-maker, is building a ‘Gigafactory’ to make conventional li-ion batteries for use in vehicles and the Powerwall home battery unit, and Elon Musk (of Tesla) obviously does not believe that new technology was worth waiting for.

The cost of stored renewable energy will put a ceiling on the price of fossil fuels, and the cost will come down, in the same way that the cost of shale oil puts a ceiling on the oil price, and the cost of extracting shale oil is coming down.

The low price of oil means aviation fuel is cheap, but the relation could conceivably change in extreme circumstances. In theory, if demand for the other fractions of crude oil falls, aviation fuel would get more expensive. In the simple case of two products A and B with production of them in a fixed ratio, increasing demand for A will mean more of B is produced and B will usually be cheaper as a result. Similarly, less demand for A makes B more expensive, and more demand for B makes A less expensive. The economics is more complicated for fractions of oil, partly because the fractions produced can be varied by using heavier or lighter oil, and by cracking or coking. This image for the fractions of crude oil is from “Getting gas from Crude” by Heading Out, March 13, 2006 (theoildrum.com), and is available under a Creative Commons license.


This … “General Electric Bids its Fuel Efficient Future on 3D Printing” by Theo Valich, July 15, 2014 (vrworld.com) is about ‘printing’ fuel efficient nozzles. 3D printed parts can also be lighter, because the best design might be lighter and too complicated to make by conventional methods. (Whole jet engines have been 3D printed, but only two copies of an old engine that were put on display.)

While cheaper oil is good for air travel which is good for sales of planes and their engines, the lower oil price reduces the benefit of fuel efficiency, making it harder to sell expensive fuel-efficient aircraft, according to “Lower Jet Fuel Prices Shake Up Aircraft Market” by Robert Wall, Jan. 19, 2015 (wsj.com). General Electric invested in oil & gas at the top of the market, and the WSJ’s “Shake Up” piece implies a risk that the low oil price will hit sales of GE’s efficient engines. However, recent sales news has been good – “GE Aviation tallies $19 billion in engine deals at air show” by Chelsey Levingston (daytondailynews.com). There’s a piece I like about GE’s tech opportunities – “Big Data, The Industrial Internet, And How GE Stands To Profit” by Adam Stockmeister, Jun. 23, 2015 (seekingalpha.com).

Against GE, there’s a history of underperformance with the share price of $26.78 (on July 3, 2015) well below the price of $41.40 on Sept 28, 2007. There’s also a lot of debt, which will be reduced due to the divestment of financial operations, but they’re having problems closing a big acquisition (Alstom, it’s French), while the disposal of Electrolux has hit regulatory opposition. GE’s unions won significant improvements in wages, healthcare and pensions, see “GE Announces Details of Proposed Labor Contracts” June 24, 2015 (businesswire.com). They might expect another good deal in four years time. GE were a top-ten beneficiary of export subsidies that have ended, find “Boeing’s Bank” below.

Boeing Co (BA) contradict the WSJ’s “Shake Up” piece – “Cheaper oil to boost aircraft sales, Boeing official says” March 2, 2015 (thenational.ae), emphasizing the effect of cheaper fuel on increasing air travel.

Boeing’s 787 Dreamliner has attracted some sensational headlines, such as “Boeing 787 software problem could lead planes to fall out of the sky”. Further investigation shows the problem was quickly solved with a software update. I like the headline “Turn your Boeing 787 off and on again, or it will crash”, but for an unsensational overview I suggest “ANALYSIS: After three years in service, how is 787 performing?” by Stephen Trimble, Nov 14, 2014 (flightglobal.com). Apparently, airlines have tolerated various glitches because they like the fuel efficiency. Al Jazeera have been highly critical of the 787, see “Review: Al Jazeera’s 787 Report Misses the Mark” by Vinay Bhaskara, 9/10/2014 (forbes.com). I’m not reassured by the author’s claim that it’s hard to find any major industrial plant without drug use. Boeing claim to have standard drug-testing procedures. I checked the titles of articles on Seeking Alpha back to Sept 11, 2014, they are mostly positive, and the few negative titles I saw were not concerned with safety.

Competitor Airbus Group SE (EPA: AIR) has also had incidents. On Wikipedia, the four incidents involving the A320 family in 2015 can be summarized as: murderous co-pilot (fatal), wind shear (injuries), loss of height (unexplained) (injuries), and landing accident (no-one hurt). About a military Airbus driven by compter-controlled propellors – “Fatal A400M crash linked to data-wipe mistake” by Leo Kelion, 10 June 2015 (bbc.co.uk).

Boeing subcontracted sub-assemblies for the 787 to various suppliers, it was supposed to reduce costs but the cost reductions have been slow. The 787 is expected to break even this year. The company has good cash flow, but the accounting is complicated – “Boeing 787 unit loss declines, but deferred costs rise” by Stephen Trimble, Apr 22, 2015 (flightglobal.com). Those deferred costs were for production and the amortization of tooling, and they rose to over $30 billion. A deferred cost is an expense that will be recognised later, which is accounted for as a notional asset. The notional asset gets wiped when the cost is paid (or recognized as paid, on the books). The $30 billion of deferred costs will hit income as they are recognised. Boeing’s half-a-trillion dollar backlog should keep the cash coming in, but the deferred costs could build up with it. I suggest doing your own research in the area before investing a lot in BA.

“Boeing’s Bank” has shut – “Export-Import Bank Closes: Kill Subsidies To Cut Federal Liabilities, Promote Economic Fairness” by Doug Bandow, 6/30/2015 (forbes.com). The ‘bank’ provided finance at below market rates (for $67 billion of Boeing’s sales over seven years), and took on the risk of non-payment. From the article (page 2) it looks like the financing was not a major factor in closing sales, so if there was any rush to buy Boeing before the bank closed, it was probably not a stampede and not likely to have a massive effect on future sales. Other agencies to promote exports remain.

Boeing and Airbus have been fighting each other over subsidies for years, see “Boeing warns Airbus over reports of state aid” by Russell Hotten, 17 June 2015 (bbc.co.uk).

This is about how China is struggling to make commercial airliners, and the author’s reasons are rooted in the technical complexity of a modern airliner and the organizational complexity of making them – “Can the Chinese Create a Competitive Commercial Aviation Industry?” by Thomas Duesterberg, Jan/Feb 2015 (aspen.us). The Dreamliner seems to have been a struggle for Boeing, which I put down mostly to the size of the challenge rather than any fault of the company.

Airbus in China” (airbus.com) is best read after the previous link. A cynic might say it’s about how Airbus are giving China their technology and know-how, undermining the future of European and US aircraft manufacturing.

Free routing (next) could mean fewer planes are required for the same number of passengers carried.

Free routing

Flight along legacy air corridors means inefficient zigzagging, and there are moves to bring routing into the twenty-first century.

Free flight” Sep 6th 2014 (economist.com) is about the prospect of new technology allowing pilots to “free route” and choose direct routes when possible, with the potential of quicker journeys and lower costs. Direct routes increase the ‘useful miles flown’ per day with no increase in the cost of fuel, aircrew pay, maintenance, or other overheads except for the cost of the new technology. Trajectory-based routes include altitude, and instead of ascent, level, ascent, level, descent, level, descent (etc.), a smoother route in the “height” dimension adds to the effieciency.

One company The Economist mentions is Indra Sistemas SA (IDR:Soc.Bol SIBE), a diverse Spanish consulting and technology multinational which includes developing air traffic management systems (on their “Air traffic” page).

There’s also a promo which summarizes “Free Routing” on “New Space to Fly” Dec 3, 2014 (click “More”), but to download the radio program you probably have to be in the UK (and you’ll need to download the BBC iPlayer).

The US has its “Next Generation Air Transportation System” (Wikipedia) aka “NextGen”, which will also allow the selection of direct flight paths. Implementation started in 2012 and should be complete by 2025.

Security is not mentioned in the Economist piece about free routing. The Wikipedia piece about NextGen in the US only mentions that crucial signals are “unencrypted and unauthenticated”. The signals are ADS-B (Automatic Dependent Surveillance Broadcast). The paths involved are from transponders in airplanes to other airplanes and to air traffic control. The transponders receive a time signal from GPS satellites from which they calculate their position, which is then transmitted.

I’d say that the more automated a system is, generally the more damage can be done by hacking it. A system which manages too much is more likely to have unforeseen glitches, and hopefully the authorities know what change and what pace of change is safe. If a dynamic automated system operates safely in the air, it could strengthen the case for allowing driverless cars and coordination of their operation on the ground.

One problem with global roll-out is that many Air Navigation Service Providers run systems that are behind the capabilities of modern aircraft, and the focus in air traffic management is on encouraging upgrades to allow harmonization and interoperability. That might need to be complete in a region before starting a program of radical change (the world’s nine regions are mapped here).

I’m guessing that another inefficiency exists which technology could fix – when a flight is cancelled, there will be newly available slots for take-off and landing. These are likely to be wasted quite often unless the cancellation is a long time in advance, either because the information system can’t cope, or because people prefer to play safe and stick to the filed flight plan, or stick to the plan to avoid the stress and effort of making a new plan within a tight deadline.

Free routing increases the capacity of airplanes to carry passengers between airports (i.e. more flights per airplane per week), and closer spacing between aircraft increases the capacity of the airspace. If those capacities increase, the effect on an airport depends on various factors (these are fairly abstract and complicated) –

• In principle, an airport with excess capacity which is limited by the capacity of the airspace would benefit the most, but in practice there’s no reason to have provided the excess capacity in the first place.

• An airport at around full capacity which can increase its capacity (e.g. by adding a runway) would have the opportunity to increase passenger volume.

• ‘Second choice’ airports (further from a city or other destination) get the leftovers, and volume depends on the capacity and pricing of their more convenient competitors in relation to total demand for flight to the destination.

• If an airport and its airspace both have excess capacity, there’s no benefit from increasing the capacity of either.

• If the infrastructure is not a constraint, a city can handle a lot of visitors and departures, but a resort will have limited capacity and too much expansion could ruin the experience.

Although fairly complicated, that’s still a simplified version because it ignores time (the difference between peak and off-peak times at airports) and geography (airspace could be congested to the north but not to the south). There are also sub-cases such as where spare capacity becomes a shortfall, and the statements are rough rather than rigorous.

All of those considerations could have some effect on hotels, attractions, conference centers etc. Negative effects only seem likely on a local level, if an airport becomes stranded because a nearby airport can handle more traffic.

The more efficient use of planes will mean lower sales of planes, engines and other parts, unless air travel increases by enough to compensate. Lower costs and increased capacity from free routing and associated upgrades will help to increase air travel, and airlines, airports, car rentals and hospitality will generally see higher volumes than otherwise. Airports may be best placed to capture the cost benefit, but it depends on regulators allowing it.

Rail can sometimes compete with air travel and transport, and while trains obviously can’t “free route”, there is scope for information technology to allow the spacing between trains to be reduced, increasing capacity without needing to lay new track. They’re talking about it in the UK, and working on it in Australia, see “Advanced Train Management System” (lockheedmartin.com). Lockheed Martin Corporation (LMT) are best known for expensive jet fighters, see “Pentagon’s ‘Too Big to Fail’ F-35 Gets Another $10.6 Billion“, but their “What we do” list is diverse enough to include biometrics and robotics.

Existing flight management

Software has already made flight planning easier, see “SkyDemon Flight-Planning Features“. The system is visual, and a route can be made by setting waypoints, and then edited for example by dragging, which will be needed if a warning is generated that the flight goes through restricted space. The feature suggests that at least a degree of free-routing has already been implemented, although NextGen is not due for completion until 2025. Journey time and fuel use are displayed.

Flight plans can still be submitted on forms filled in manually, and you can download a flight plan form (PDF) here.

According to Wikipedia’s “Flight plan” page, for domestic flights a flight plan should be submitted at least one hour before departure, and for international flights, the minimum is up to three hours before departure. Those are recommendations, and it’s possible for a flight plan to be submitted after take off.

The existing systems are already sophisticated, but so far as I can tell, if a change in the weather means that a different route would be more fuel efficient or avoid delay, the pilot is likely to stick with the flight plan that’s been filed, rather than go to the trouble of having a more efficient flight plan calculated and submitted. BTW if severe weather threatens safety, an airplane will usually turn back or be routed around it. In “AirAsia QZ8501: Plane crash blamed on weather“, it’s reported the pilot requested permission to climb to avoid bad weather. Big modern planes have weather radar that usually allows problems to be seen in time, but sometimes (rarely) pilots can under-estimate the risk or make mistakes when conditions get worse quickly.

TRACON stands for “Terminal Radar Approach Control” and a TRACON handles the descent and approach to an airport, usually for more than one airport. A TRACON jurisdiction is divided into sectors with a controller for each sector. The controllers in the TRACON have radar view of all the sectors and can easily communicate with the other controllers, which allows a smooth transition from one sector to another. According to nasa.gov, there is not the same communication between TRACONs, and as a result some routes are longer to preserve safety. Presumably that restriction will be phased out under “NextGen”.

For more background see Wikipedia’s “Air traffic control“.

Holographic radar

The Economist’s piece about Free Flying describes the limitations of existing radar. While radar might never be as accurate as positioning by satellite, using satellite signals depends on systems in the plane as well as the satellite. If there’s an incident or failure on the plane, or if anything such as a solar storm affects the satellites or the ability to pick up the signal, good ground radar is needed. The good news here is that ground radar has just got better.

When Russian jets fly dangerously close to airliners in the Baltic, the Russians don’t respond to radio or give the normal transponder signals that would give position data. The usefulness of ground radar in tracking uncooperative jets depends on how stealthy the jets are. However, it’s been suggested that the military pass on some of their radar surveillance data to civilian air traffic control, which implies that the jets are detectable by radar (see “Free route aspirations face rogue jet threat” below).

Holographic radar has been pioneered by Aveillant, a privately owned spin-off from Cambridge Consultants in the UK. According to the sales blurb – “What makes Holographic Radar different?“, Aveillant’s “static staring” system is on target 100% of the time, compared to under 1% “dwell time” for scanning radars. For decades, engineers have focused on squeezing more info out of that 1%. Previously, radars collected too much information to process effectively, and they operated by electronically filtering out the least useful info. Aveillant’s founders say they realized that advances in digital technology meant the filtering could be avoided.

This – “Aveillant pioneers win industry accolade” by Aimee Turner, November 28 (airtrafficmanagement.net) explains the technology fairly simply, and I’ll quote – “it observes the complete airspace”. It confirms that Aveillant have overcome a key problem – telling a wind turbine from a plane.

There’s more about the technology from suppliers Boston Limited – “NVIDIA GPUs and Supermicro UK servers fuel Aveillant’s Holographic Radar™” January 13, 2014 (sourcewire.com).

This is the most comprehensive piece about the tech – “All-seeing EYE” May 6, 2015 (aerosociety.com).

The radar is good for knowing the position and velocity of drones, which could favor their civilian use.

Aveillant’s CTO is making a 45 minute presentation at the Military Radar Summit 2015 (agenda), on “Holographic RadarTM – Target Centric Surveillance”.

Satellite communications

About satellites and safety – “SB Safety installation marks flight deck comms revolution” 14 August 2014 (inmarsat.com).

About satellites and broadband – “Honeywell partners on advanced in-flight connectivity system” Apr 14 2015 (seekingalpha.com).

Satellite providers angling for new business in air-traffic changes” – More frequent reporting of airplane position will allow them to fly closer, i.e. not so far ahead or behind each other. The increased traffic allowed will be good for airport business, though for a single airport it depends on how often capacity is reached, what limits capacity, would an extra runway be feasible, etc. Demand from aviation for satellite services looks likely to grow in the long term, although it will drop whenever flights or miles flown drop.

The first two links refer to Inmarsat, a UK company which I’ve put on the “Airport stocks list”. A US stock could benefit from the same demand –

Iridium Communications Inc (IRDM).

The forward P/E is under 10 (as at July 3, 2015). Morningstar’s financial history page shows –

Operating cash flow about twice earnings (very roughly).
Capex about twice OCF.
The returns metrics are poor single digit figures.
Income has grown quickly but the rise in the number of shares means that EPS does not show a clear growth trend.

Iridium depends on successful launches for cash flow to cover interest on debt. I have to give credit to slboomer and 2tired2talk for their comments about launches, cash flow and debt under “Betting Against Beta With Iridium” by Celan Bryant, May 4, 2015 (seekingalpha.com). An obvious point is to be sure IRDM have good insurance before investing in them ahead of critical launches. I don’t know if it’s possible to insure every aspect of deployment. Iridium’s big investment could make life tough for competitors. I’ve checked that two European projects won’t compete – the European Data Relay System will relay satellite data to ground stations by laser, and the EU Sentinel satellites will monitor the earth and the data will be freely available.

See “Iridium NEXT — Iridium’s second-generation global satellite constellation“. It’s probably just coincidence that Iridium use “NEXT” and “second-generation” while “NextGen” (above) is the big Air Transportation System upgrade. Iridium talk about “truly global mobile communications on land, at sea and in the skies”.

Getting back to satellites in general –

GPS and the European equivalent GALILEO are provided by governments, but it’s a key part of products and services from Iridium and many other companies.

Why satellites fail?” by Marryl Azriel, March 7, 2013 (spacesafetymagazine.com)

What would happen if all satellites stopped working?” by Richard Hollingham, 10 June 2013 (bbc.com). Air travel is one of the casualties. The author does not seem certain about the far-reaching consequences, and maybe few people if any know for sure.

Satellite insurance” (Wikipedia)

This is of historical interest, it’s a long slow-burner but the tension gets high – “Elon Musk’s Space Dream Almost Killed Tesla” by Ashlee Vance, May 14, 2015 (bloomberg.com).

3D radar

This is just to give some idea of what radar can already do (i.e. non-holographic radar). 3D radar has applications in weather monitoring, air defense, surveillance and the imaging of underground structures. Some links –

3-D Radar of Mystery Object That Hit Louisiana” by AccuWeather.com Staff, 10/16/2012 (accuweather.com)
Acquisition of 3d-Radar – Chemring Group PLC” about mapping underground structures
British fleet’s new radar system can detect a supersonic tennis ball 25 km away” by David Szondy, March 19, 2013 (gizmag.com)

Other staring radar

My amateur guess was that Aveillant’s holographic radar could not do the tennis ball trick (in the previous link), because the best way to pick up a reflection from a small distant fast-moving object is to focus a lot of energy on it, even if it’s only for a short time as the object intercepts a swept focused beam. However, the private South African company Reutech has demonstrated a staring radar array which they claim is good for detecting and tracking small fast-moving projectiles. It’s good at discriminating between projectiles and complex clutter, which seems similar to Aveillant’s radar being able to tell wind turbines from planes. Although developed for military applications, Reutech claim possible applications in automotive, mining and security.

Possible radar losers

It’s possible that staring radar threatens part of some companies’ defense revenue, such as Raytheon Company (RTN). I stress ‘part of’, e.g. Raytheon look well positioned with their expendable drones (which cost about $400,000 each, but as they’re launched from aircraft to jam enemy radar, they wouldn’t be as cheap as surveillance drones).

Thales SA (HO:Euronext Paris) supply air traffic management systems (thalesgroup.com). They combine radar and non-radar for surveillance, which may provide some protection from Aveillant’s radar, and they should benefit from the need to upgrade the CNS infrastructure (communication, navigation and surveillance) to support free routing and associated improvements. See also “Thales launches STAR NG, revolutionary new ATC radar with specific dual civil/military applications“. The name “STAR NG” rather suggests “staring”, as in Aveillant and Reutech’s staring radar. The picture looks like it’s of a directional radar, but there’s no caption to say exactly what is pictured. The radar is an “S-Band Primary Surveillance Radar (PSR)”, a kind Aveillant claim their holographic radar is superior to.

This is better than Thales’ sales spiel at explaining the need for integrated civil/military surveillance – “Thales’ STAR NG heralds primary renaissance by Aimee Turner, June 15, 2015 (airtrafficmanagement.net). The immediate problem is (probably) Russian jets flying close to passenger aircraft over the Baltic Sea, as described in “Free route aspirations face rogue jet threat” by Aimee Turner, June 24, 2015 (airtrafficmanagement.net). I’m not sure how free routing aspirations are threatened, as uncooperative aircraft can fly just as close to planes in an air corridor as they can to free-routing planes. The article says the jets were close to the EU region’s borders, but the European Commission says –

    “Apart from two areas under Russian sovereignty at the far end of the Gulf of Finland and off Kaliningrad, the Baltic Sea is now under the jurisdiction of European Union Member States.”

Keying “russian jets in ” into Google’s searchbox gets a list of prompts with continuations such as English Channel, American airspace, Irish airspace, Alaska, etc. That only shows what people have been searching for, but I checked for the English Channel (between England and France), and found “UK scrambles jets as Russian planes and ships spotted“. IMO using relatively cheap drones to fly dangerously close to Russian jets might be effective (when they are not close to airliners), as it’s clear who would have the most to lose in a collision, but I can’t be sure about feasability and the likely responses from Russia need to be considered. In any case, wherever there are uncooperative jets it will be easier for Thales to sell their integrated civil/military surveillance, but I’m not tempted to buy the stock due to the possible impact of Aveillant’s radar.

AeroVironment, drone maker

AeroVironment, Inc. (AVAV) makes drones and charging stations for electric vehicles. Most of AVAV’s drone business is military, but IMO the opportunity is (or was) in civilian drones.

Data from the EU Sentinel satellites (linked to above) will be free, requiring only registration. For applications where Sentinel’s spatial resolution of 10 m in the visible spectrum is good enough, observation drones might not get the business, although they have the advantage of being able to fly under clouds and as frequently as needed. The satellite’s resolution will not be good enough for the inspection of infrastructure like roads and pipelines.

AVAV have been concentrating on the upmarket “Enterprise” segment of the civilian drone business, but there’s a strong hint in this – “AeroVironment (AVAV) Timothy Conver on Q4 2015 Results – Earnings Call Transcript” Jun. 30, 2015 (seekingalpha.com) that they will enter the consumer drone business (find “consumer appetite” in the transcript), bringing some kind of technological advance to the market.

The consumer market seems like an easy one for anyone to enter and likely to become highly competitive and low margin. AVAV should probably have entered the market earlier rather than later. If they have an advantage that transfers to the consumer market, I can’t see it. “The 7 Best Agricultural Drones on the Market Today” by Andrew Amato, 1, 2014 (dronelife.com) has the “Lancaster” drone from PrecisionHawk at number 3, with LIDAR among other features, and there’s no mention of AVAV. There’ll be more drones on the farm as restrictions ease – “Why 2015 is the year agriculture drones take off” by Clay Dillow, May 18, 2015 (fortune.com).

In “Drones Revolution Means Big Data Cloud Services” by Colin Snow, February 18, 2014 (blogs.sap.com), the president of PrecisionHawk imagines analytics app-stores. That has me thinking, should AVAV be developing an analytics app-store, will they put out their own apps, and will they be late again.

Military drones, Shaving costs” Feb 17th 2014 (economist.com). In short: AeroVironment’s Raven – $76 thousand, University of Virginia’s Razor – $2 thousand. The two drones won’t be exactly comparable, and control through a smart phone with apps does not sound secure.

Management are keeping the cash generated by the business to fund growth, and the cash needed to fund growth depends on how opportunities develop. It’s good that management realise growth is a marathon, not a sprint (my cliche, not management’s).

The financial history on Morningstar is poor. The return metrics have declined since 2006 to pathetic levels, with return on assets, equity and investment all below 1% for fiscal 2015. However, the metrics are based on income, and the operating cash flow and free cash flow have been much higher than operating income for the past three years.

Overflight Fees

One reason for a plane to sometimes avoid a direct route is the overflight fees charged by government agencies (overflight means ‘flies over a country without taking off or landing in it’). The FAA‘s fees look like they go up every October, and they’ve gone up from $43.82 in 2012 to $56.86 in 2014 (per 100 nautical miles). At least it’s simple, unlike the algebra on Eurocontrol.

Every country has the right to deny overflight but there are agreements between countries to allow it, usually under the “Freedoms of the air” (Wikipedia) framework. “Freedom” should not be confused with “no fee”, as the deals to allow overflight also allow a fee to be charged. The fees have to be “reasonable”, which can mean the same fees as for domestic airlines, but the reasonableness of fees can still be disputed.

Russia did not sign up to the “Freedoms of the air”, but they still allow overflights (usually), and earn about €300 million a year from European airlines. They’ve threatened to stop foreign overflights, but it would hurt them more than the airlines according to “Russia’s Still Not Quite Getting These Trade Sanctions Things; Now It’s Overflight Rights” by Tim Worstall, 9/09/2014 (forbes.com). I’m not so sure. Russia doesn’t seem likely to ban overflights by Chinese airlines, or any airline based in a country which has not hit them with sanctions. I’m not sure that European countries could do much if their airlines complained about competitors having the advantage of overflying Russia.

Greece is probably well positioned (literally) to collect overflight fees.

Exotic air passenger transport

IATA’s forecast to 2034 has something missing – “London to Sydney in just two hours? By 2030 travellers will jet the world on a 13,750 mph spaceship” October 2, 2011 (dailymail.co.uk). Unfortunately, in November 2014 Virgin’s spaceplane broke apart after prematurely deploying “feathers” that were meant to slow the descent on reentry, and prevent burning up in the atmosphere. I’d guess if anyone has the will and resources to persist through such an ambitious project, it would be the Chinese government, and success would enable them to leap ahead without the expense of working up to a dreamliner. Their “humans in space” capabilities are covered in Wikipedia’s page about the Tiangong-1 space station.

Passenger airplanes that look like stealth bombers would have lower drag and better fuel efficiency, if they can solve problems like yaw (horizontal rotation) and where to put the windows – “Northrop Grumman’s Futuristic Flying Wing Cribs From its Past” by Jason Paur Gear, 01.25.12 (wired.com).

Electric planes are a long way from being commerical. This plane can fly for up to an hour, and I imagine serious range anxiety.

Solar Impulse have already broken the record for non-stop solo flight with their 118 hour flight from Nagoya in Japan to Hawaii. The solar plane is a sophisticated piece of engineering, but there are practical problems in applying the principles to commercial aircraft. The plane had the wingspan of an Airbus but only carried the pilot, so a purely solar airliner is not feasible. Putting solar cells on airliner wings means less fuel is burned to generate electricity, but the cells and the bonding to the wings would need to be very strong because damage would produce drag and airlines like to keep maintenance needs as low as possible. There’s the question, would and should the minimum safe fuel requirement be reduced to take account of the solar energy generated.

Facebook have test-flown a prototype solar powered drone with an airliner’s wingspan and a car’s weight.

The Autonomous Human Drone Taxi” (lab.moovel.com). The hanging seat is probably too scary for most passengers. Although it’s only ‘proof of concept’, adding a cabin would increase the weight. It might suit applications like supplementing emergency response in remote areas, rather than city use, if the necessary range is achieved.

Links to gurufocus

Altman Z Score (bankruptcy risk)

AVAV safe, BA grey, CAR distress, DIS safe, GE distress, HTZ distress, IRDM distress, JBLU grey, LMT safe, MAR safe, RTN safe

The score indicates the risk of bankruptcy within two years, with a “grey” zone between the distress zone and the safe zone. It ignores cash quantities because they were not usually disclosed when the test was invented, but it has had good statistical support many years after its invention. Professor Altman’s later test is available, for a fee. Like all financial tests that I know of, the Altman Z only considers figures in the main accounts, i.e. nothing off the balance sheet. If your favorite stock is in the distress zone, check the table of history which gurufocus put at the bottom. If it’s been in distress every year since 2005 without bankruptcy or other failure, the indication has been false for at least 8 years.

Beneish M-Score for earnings manipulation


Lockheed Martin (LMT) are reported as being an earnings manipulator, but gurufocus did not complete the calculation so the result should be ignored. The M-Score is unreliable (I don’t mean the calculation by gurufocus) and if a company fails it, further investigation could show there’s no real problem.


These are on Spreadsheets used for “Air travel – an overview”. I have not reproduced the data from the World Bank’s tables. It’s probably easiest and safest to check my work by reproducing it from the sources, find “was taken from the press release” and “taken from or derived from” above.

To get the historic data in similar categories to the forecast data, I had to calculate the air passengers carried for North America. I did that by adding the figures for USA, Canada and Mexico. That missed out a number of countries, mostly Carribean or Central American, at least according to Wikipedia’s list (find “Countries, territories, and dependencies”). As a result, the historic totals are under-reported in my spreadsheet and charts. That’s in the wrong direction to explain the discontinuity between the historic data and the projected data, which shows as a drop from 2013 to 2014.

And finally …

You’ve probably heard of ‘Lawn chair Larry’ (Darwin awards). This YouTube video takes 39 secs before getting to Larry. There’s also “On a high: Adventurer becomes first person to cross Channel in chair attached to helium-filled balloons” by Vanessa Allen for the Daily Mail, 29 May 2010.

Thank you for reading this.

DISCLAIMER: Your investment is your responsibility. It is your responsibility to check all material facts before making an investment decision. All investments involve different degrees of risk. You should be aware of your risk tolerance level and financial situations at all times. Furthermore, you should read all transaction confirmations, monthly, and year-end statements. Read any and all prospectuses carefully before making any investment decisions. You are free at all times to accept or reject all investment recommendations made by the author of this blog. All Advice on this blog is subject to market risk and may result in the entire loss of the reader’s investment. Please understand that any losses are attributed to market forces beyond the control or prediction of the author. As you know, a recommendation, which you are free to accept or reject, is not a guarantee for the successful performance of an investment.

Ubiquiti Networks – charts up to Q3 2015

Disclosure – I’m long Ubiquiti Networks, Inc. (UBNT).

Closing price May 22, 2015: $30.46

The company and the business model

From the company’s 10-K – “Ubiquiti Networks develops high performance networking technology for service providers and enterprises.” The service providers are typically Wireless Internet Service Providers (WISPs). “Our technology platforms deliver highly-advanced and easily deployable solutions that appeal to a global customer base, particularly in under-networked markets.” Manufacturing is outsourced, resulting in low capex. Sales costs are low as the company relies on an internet forum/community to evangelise the products, which allows disruptive pricing, while the pricing encourages the evangelism. Headcount is low and Ubiquiti are able to concentrate on R&D.

About this piece

This is an update to my previous piece, “Ubiquiti Networks – charting volatile revenue” February 18, 2015 (wordpress.com). I’ve written less in this update, making it easier to refer to the charts while accessing other material. I recommend reading this – “Ubiquiti Networks’ (UBNT) CEO Robert Pera on Q3 2015 Results – Earnings Call Transcript” May. 7, 2015 (seekingalpha.com). The CFO had left and only the VP of Investor Relations accompanied the CEO.


I’ve used 10-Qs and 10-Ks from the company’s SEC filings page.

Revenue and earnings

Ubiquiti revenue and earnings to Q3 2015 and Q4 guidance

In the next chart I’ve fitted trend lines, and the chart includes an explanation of why I don’t trust them for making projections. That tends to be my general attitude regarding trend lines fitted to financial results. If you want to get results such as “Standard Error of Slope” online, you can use the Linear Regression Analysis page on The Chinese University of Hong Kong. You’ll need to navigate via “Data modelling” and “Linear Regression”. Although the chart’s scale is in millions, the formulas are based on thousands, and that’s true for all the trend lines in this piece. There’s more about statistics in the blog post I linked to at the top.

Ubiquiti revenue and earnings to 2015 E

Ubiquiti margins to Q3 2015

Ubiquiti margins to 2015 E

Cash flow

“Cash from operations” includes changes in working capital which can sometimes be volatile. The investing cash flow accurately represents capex, consisting of only “Purchase of property and equipment and other long-term assets”.

Ubiquiti quarterly cash flows to Q3 2015

Ubiquiti quarterly cash flows per share to Q3 2015

Revenue by regions

Ubiquiti quarterly revenue total and by geography

The R-squared value of 0.753 means the trend line explains 75.3% of the variation in total revenue. The next chart uses the same data, but drops the total and puts trend lines on the regions.

Ubiquiti quarterly rev by geog with trends

Product types

Ubiquiti quarterly revenue by product type stacked

My data for the current two product types starts from Q1 2014, and growth since then has been slower. Adding the coefficients in the trend line formulas (below) gets 3056.000-39.607 = 3016.393, which implies about $3 million growth in sales per quarter, which is about 2.0% based on Q3 2015 sales of $147,456 thousand, or 8.4% annually (although projecting an annual growth rate would contradict the assumption of linear growth implied by the trend line). The growth between Q1 2014 sales and Q3 2015 sales works out to $2,962 thousand per quarter, which is very close to the growth implied by the trend line formula.

Ubiquiti quarterly revenue by type with trends

Correlations between regions and between product types

The charts in this section help to answer the questions, how closely do sales in the regions move together, and how closely do the product types move together.

The data for regions runs from Q1 2012 to Q3 2015, and the general direction in the charts is from the bottom left to the top right. The slope of each trend line is given by the number in front of “x” in the trend line formulas, for example “0.524x” in the next chart means that for every dollar sales increase by in EMEA (Europe, Middle East and Africa), sales in North America increase by $0.524, on average, according to the line fitted.

The slope does not depend on the units (whether the data is in thousands or millions of dollars). The constant 6927.608 in the next chart implies that sales in North America would be $6,927.608 thousand (i.e. about $6.9 million) if sales in EMEA were zero. I do not regard that figure as accurate or meaningful, however I decided against forcing the lines to pass through the origin, which is sometimes done when there’s a good reason to believe that variables have an underlying relationship which is strictly proportional.

Ubiquiti quarterly revenue scatter chart EMEA

The red R-squared value of 0.206 in the chart above means only 20.6% of the variation in revenue from South America is explained by variation in revenue from EMEA in conjunction with the line fitted (the red one). Sales from South America are mostly independent of sales from EMEA, or in simple terms, even though both regions have trend lines that slope up, sales from South America can easily go down while EMEA goes up (which has happened in five of the last fourteen quarters).

The two regions where sales are the most in step with each other are EMEA and Asia Pacific, where 69.3% of the variation in one is explained by the movement of the other in conjunction with the line fitted.

If you want the correlation, taking the square root of R-squared gets R, the correlation coefficient. R-squared is probably more intuitive, as it measures the proportion of variation explained by a fitted line.

Ubiquiti quarterly revenue scatter chart N America

In the next chart I’ve zoomed in on the area that matters, but I also show a view which includes the origin. The line fitted has a negative slope, which implies that more sales in “Enterprise” mean less sales in “Service provider”, and vice versa. The R-squared value is only 0.360, and in my opinion the relation implied by the negative slope is likely to be spurious.

Ubiquiti Enterprise tech on Service provider tech - scatter

The spreadsheets

Ubiquiti revenue and earnings to Q3 2015 spread

Ubiquiti revenue and earnings to Q3 2015 formulas

Ubiquiti cash flow to Q3 2015 spread

The formula view below shows that in the spreadsheet above, most columns are a mixture of data and formulas, and in some columns the formulas vary. The reason is that cash flows for a single quarter are only in the SEC filings for Q1. The result is the kind of complication that makes spreadsheet errors more likely, even though each formula is only simple arithmetic.

Ubiquiti cash flow to Q3 2015 formulas

Ubiquiti segments spread part 1

Ubiquiti segments spread part 2

Ubiquiti segments spread part 1 formulas

Ubiquiti segments spread part 2 formulas

Thank you for reading this.

DISCLAIMER: Your investment is your responsibility. It is your responsibility to check all material facts before making an investment decision. All investments involve different degrees of risk. You should be aware of your risk tolerance level and financial situations at all times. Furthermore, you should read all transaction confirmations, monthly, and year-end statements. Read any and all prospectuses carefully before making any investment decisions. You are free at all times to accept or reject all investment recommendations made by the author of this blog. All Advice on this blog is subject to market risk and may result in the entire loss of the reader’s investment. Please understand that any losses are attributed to market forces beyond the control or prediction of the author. As you know, a recommendation, which you are free to accept or reject, is not a guarantee for the successful performance of an investment.

IPG Photonics – charts up to Q1 2015

Disclosure – I’m long IPG Photonics Corporation (IPGP).

There are a few remarks about particular issues, but I mostly let the charts speak for themselves. My sources are the SEC filings and the press release “IPG Photonics Reports First Quarter 2015 Revenue Growth of 17%” on IPG’s site.

Charts of quarterly data

In the first chart, for Q2 2015 “Net sales”, I used the figures for “revenue” in the guidance ($215 million to $225 million). “Revenue” is likely to mean the same as “net sales” because the earnings release gives similar figures for Q1 2014 “Revenue” and “Net sales” ($170.6 million and $170,575 thousand).

IPG results to Q1 2015 bars and line

In the short period charted, I’d say Q2 and Q3 look strong, but the 10-K for 2014 has –

    “Historically, our net sales have been higher in the second half of the year than in the first half of the year.”

IPG results to Q1 2015 stacked

IPG EPS to Q1 2015

IPG EPS growth to Q1 2015

I have not charted quarterly Other Comprehensive Income, but annual charts further down show a big OCI loss for 2014 due to “translation adjustments”, i.e. the effect of changing exchange rates on the U.S. dollar value of assets and liabilities. For Q1 2015, the OCI loss was $38,276 thousand, leaving comprehensive income of only $19,070 thousand.

Cash flow charts

In the cash flow charts below, cash from operations includes variation in current assets and liabilities, particularly inventories, accounts receivable and accounts payable. If I’d also shown cash from operations without those movements (still with depreciation, stock-based compensation, etc. added back to net income), the resulting chart might look smoother, but it’s a lot of work.

For some companies, it would be essential to use capex rather than cash invested, because cash put into short term investments is more like parking cash for a while than an investment in the company’s operations. Some long term investments can also have little to do with investing in operations.

In IPG’s case, there were “Purchases of short-term investments” of $25,451 thousand in 2011, and exactly the same amount was “Proceeds from short-term investments” in 2012, due to the investments maturing. (Financial activity in 2012 included a stock offering, a special dividend, and buying out a minority interest.) As a result of the short-term investment, the investment flow I’ve used overstates the cash invested in IPG’s operations in 2011, and understates by the same amount in 2012. I only use the charts to get a general impression and I’m not concerned by shifting a portion of old investment by a year.

The short-term investment accounted for 32.2% of the investment flow in 2011, and 46.1% in 2012. There were no purchases or proceeds from short-term investments in other years from 2009 to 2014. In 2013 there were “Proceeds from sale of investment”, but only worth $495 thousand.

For comparison, Net cash used in investing activities rose from $10,639 thousand in 2009 to $90,080 thousand in 2014.

The cash invested is dominated by investment in the company’s operations. “Purchases of property, plant and equipment” accounts for most of the investment flow ($88,601 thousand, or 98.4% in 2014). There’s also “Acquisition of businesses, net of cash acquired”, which hit $11.6 million in 2012, the highest amount in the past six years, and the “Purchase of intangible assets” of $2 million in 2014 also counts as an investment in the company’s operations.

IPG cash from ops against cash into investment

IPG cash from ops against cash invested per share

A more conventional chart of cash flow per share –

IPG cash from ops and cash invested per share

This chart is logarithmic, so the slope of a line corresponds to the compound growth rate –

IPG logarithmic cash flow - to 2014

The charts for growth in OCF between any two years are probably understood best if I show the spreadsheet first. Although there’s no “2014”, the table is up to date, for example the bottom row is for 2013, the only entry is “49.6%” in the column for 1 year ahead, and the increase from 2013 to 2014 was 49.6%. The figure in the top right shows growth of 30.2% (CAGR) between 2004 and 2014.

IPG CAGR CFO per share - spread

IPG CAGR CFO per share by year

Sometimes growth over five years is used as a metric. In the chart below, find the columns grouped above “5”, and you can see that growth measured over the previous five years has been over 20% for each of the past five years, i.e. for 2004 to 2009, 2005 to 2010 … up to 2009 to 2014.

IPG CAGR CFO per share by number of years

Sales, costs and profit charts

In some cases I’ve used a stacked and a non-stacked chart of the same data. If any subjective bias results from the way a chart represents data, a different type of chart might not produce the same bias.

In order to get the stacked charts, I needed to change the sign of expenses, which are negative in the 10-Ks (as indicated by brackets). For some years in some stacked charts there will be minor distortion due to the inclusion of a negative quantity, for example “Interest expense (income)” has mostly negative figures, but the absolute amounts have declined from about 5% of net sales in the early years, to 0.01% in 2014.

I changed some item-names, e.g. “OTHER INCOME (EXPENSE), Net:” in the 2014 10-K is “Other expense (income), net” in my charts, to make the name consistent with the sign change which was needed to get a stacked chart.

Interest expense is the only expense I found to be capitalized as investment, instead of charging it as an expense on the income statement. From the 10-K –

    “Expenditures for maintenance and repairs are charged to operations. Interest expense associated with significant capital projects is capitalized as a cost of the project. The Company capitalized $383 , $524 and $142 of interest expense in 2014 , 2013 and 2012 , respectively.” (thousands)

That compares to an expense of $77 and $1 for 2014 and 2013 on the income statements (i.e. not capitalized), and interest income of $319 in 2012 (all in thousands). The capitalization is small and probably conservative. The capitalization of expenses is too complicated a subject to explain in detail here, I’ll just mention that a few companies have taken it to fraudulent levels.

The items reported changed between 2006 and 2014, which presented problems. A few expenses were only significant or relevant in 2005 or in early years, for example the Series B warrants have not been relevant since 2007. 2006 is the earliest 10-K I used.

IPG sales breakdown by cost and income

IPG sales breakdown by cost and income as percent

In the next chart I’ve zoomed in and the detail is clearer, but some percentages for 2002 and 2003 are off the scale. The percentages are represented in the chart above, and they’re in the spreadsheet titled “Data as percentage of sales” near the end.

IPG income and cost as percent of sales

IPG sales costs and income

IPG operating expenses

IPG sales and profit

The following chart is unorthodox. It’s often supposed that a drop in margins warns of problems. When a company has pricing power, falling margins can warn of the erosion of pricing power through increased competition. Analysts are aware of other causes, such as variation in product mix, but it still occasionally happens that an officer at a company with high margins will remind analysts of just how high the margins are, when the analysts are probing a drop of 1% or 2%. The chart is intended to let you judge if margins predict results, as in sales, operating income, net income or cash from operations. By showing the quantities as a percentage of 2014 net sales, I got everything to fit the percentage scale on the left.

IPG margins and main results

I do not see evidence that a fall in margins predicts disappointing results, but this is a subjective exercise and you may interpret the chart differently. 2013 was a relatively poor year for margins, cash from operations, net income and operating income, but 2014 was a good year all round.

IPG earnings per share

IPG annual EPS growth

IPG Logarithmic chart of sales and profit

Comprehensive income charts

Other comprehensive income (OCI) in 2014 consisted mostly of an unusually large loss on Translation adjustments, of -$110,734 (thousand). The loss on translation adjustments was more than twice as big as the rise in net income in 2014, with a sharp fall in comprehensive income as a result.

“Translation” refers to the currency exchange rates at which assets valued in foreign currency are converted to U.S. dollar values. For the Russian operations, a low Ruble keeps costs low, and is good for net income, but a fall in the Ruble’s value against the dollar reduces the dollar value of Russian assets, which affects OCI. If the Ruble stays at a constant low level, there would be no further effect on asset values and OCI, while costs in Russia could continue to stay low, depending on inflation. I have not seen the impact of the Ruble broken out.

The impact of a low Yuan would be different. China is not a production center and does not have large long-lived assets (find “long-lived assets” below). It follows that local costs are likely to be small relative to sales in China, so there would be little benefit to costs from a lower Yuan, while the exchange rate would be bad for sales, although the size of the hit would depend on various factors including the price elasticity of demand and competitors’ costs. I don’t mean to imply that the Yuan is still falling – the Yuan’s big fall ended in January 2014.

Recently, the high U.S. dollar and low Ruble have dominated the currency effects, although the Ruble has partly recovered this year and the U.S. dollar index (DXY) has weakened since March.

25.45% of the $110,734 (thousand) translation loss is explained by the currency hit on Cash and Cash Equivalents. From the 10-K for 2014, in thousands –


The 10-Q for Q1 2015 has a “Total other comprehensive loss” of $38,276, due to Translation adjustments of -$38,319.

This is from the 10-K, about valuing foreign assets, and where they put the cash –

    “Foreign Currency — The financial information for entities outside the United States is measured using local currencies as the functional currency. Assets and liabilities are translated into U.S. dollars at the exchange rate in effect on the respective balance sheet dates. Income and expenses are translated into U.S. dollars based on the average rate of exchange for the corresponding period. Exchange rate differences resulting from translation adjustments are accounted for directly as a component of accumulated other comprehensive loss.

    Cash and Cash Equivalents — Cash and cash equivalents consist primarily of highly liquid investments, such as bank deposits, marketable securities with original maturities of three months or less with insignificant interest rate risk and marketable securities with remaining maturities of three months or less at the date of acquisition.”

Don’t worry about bars you can’t see in the next chart. Charting an insignificant quantity is my way of demonstrating the insignificance visually.

IPG comprehensive income

IPG comprehensive income per share

Geography and sales breakdown charts

Russia is included in CIS, which is in IPG’s region “Other including Eastern Europe/CIS”. CIS is the Commonwealth of Independent States, which includes Azerbaijan, Armenia, Belarus, Georgia, Kazakhstan, Kyrgyzstan, Moldova, Russia, Tajikistan, Turkmenistan, Uzbekistan and Ukraine.

IPG geography stacked

IPG geography stacked percent

IPG physical assets by location

    “Our major manufacturing facilities are located in the United States, Germany and Russia.” (10-K for 2014)

The three countries account for nearly all the long-lived assets. China accounted for 32% of net sales in 2014, but only 2.30% of the long-lived assets. (IPG have two application centers in China, in Shenzhen and Beijing.)

The evidence suggests that long-lived assets are dominated by manufacturing, and the relative size of long-lived assets by physical location is likely to be a reasonable proxy for relative production, although it is affected by foreign exchange rates and changes in them. There could also be differences in asset turnover, for example diode production is centered in the U.S., and the turnover is not necessarily the same as for other production.

IPG physical assets by location percent

IPG’s materials processing sales have grown, but other applications have not. Three small categories were consolidated into “Other applications” in 2012.

IPG materials processing and other

IPG materials processing and other - percent

Days Sales Outstanding and days of inventory charts

I fitted trend lines to DSO and days of inventory in the next chart. The DSO trend line formula shows that every year on average, DSO increases by 0.3771 of a day. However, the R-squared of 0.0707 shows the line only explains 7.07% of the variation. Taking the square root gives R, the correlation coefficient, of about 0.2659 which is low, with a 45.78% chance that there was no underlying linear trend, with random variation probably the most likely alternative. It’s conventional to reject a hypothesis with 5% or more chance of being false, as here.

The trend line formula for days of inventory shows that every year on average, days of inventory falls by 2.8046 days. The R-squared of 0.5212 shows the line explains 52.12% of the variation. Taking the square root gives R, the correlation coefficient, of 0.7219418, with only a 1.84% chance that there was no underlying linear trend. I’m wary of projecting the trend, for example a step change between the first five years and the last five years would also fit the data.

If you want to check the figures, there’s a calculator on The Chinese University of Hong Kong‘s site. Navigate – Stats toolbox Home / Correlation / Stat Sig of r. For the days of inventory, enter 10 for the sample size, and 0.7219418 for R. The results include “p=0.0184”, which translates to a 1.84% chance of the hypothesis being false.

IPG DSO and days inventory

Analysts and markets generally don’t like rising DSO or rising days of inventory. Some less sophisticated investors might even look at accounts receivable and inventory without adjusting for sales. There is some statistical evidence for the predictive power of the metrics, for example in Beneish’s work on his M-Score for earnings manipulation. If rises in DSO or days of inventory are a strong indication of trouble for IPG, the effect ought to be discernible in the next chart. I suggest looking at the chart and seeing if DSO or days of inventory predict anything for sales, income or cash from operations.

IPG DSO days inventory - sales income and CFO

So far as I can tell, rises in DSO or days of inventory have not foreshadowed problems, and neither have above average DSO or days of inventory. The only serious blip was in 2009, when IPG were affected by the recession which followed the financial crisis. I would not blame the results on the lengthening of IPG’s cash conversion cycle, especially as cash from operations was hardly affected. I would also not try to predict the next recession by looking for a rise in IPG’s DSO or days of inventory. The chart shows that the metrics fell along with sales and income in 2009.

Analysts will continue to probe any increase in DSO or days of inventory, some authors will take a gloomy view of any such rises, and so might the markets, but so long as the metrics don’t rise by or to unprecedented levels, I don’t see evidence that they predict trouble for IPG. I have not completed a full investigation, and in particular I have not looked at quarterly figures.

IPG hold high levels of inventory, keeping stocks of parts that can be assembled quickly when orders are received. This helps sales by giving customers low lead times, but the low lead times reduce the visibility of future sales. Given the high net cash and the good free cash flow, IPG might as well operate with high levels of working capital so long as it benefits sales. Growth adds to the need for inventory, and occasional preparation for higher growth and the launch of new models adds more. From the 10-Q for Q1 2015 –

    “Given our vertical integration, rigorous and time-consuming testing procedures for both internally manufactured and externally purchased components and the lead time required to manufacture components used in our finished products, the rate at which we turn inventory has historically been comparatively low when compared to our cost of sales. Also, our historic growth rates required investment in inventories to support future sales and enable us to quote short delivery times to our customers, providing what we believe is a competitive advantage. Furthermore, if there was a disruption to the manufacturing capacity of any of our key technologies, our inventories of components should enable us to continue to build finished products for a reasonable period of time. We believe that we will continue to maintain a relatively high level of inventory compared to our cost of sales. As a result, we expect to have a significant amount of working capital invested in inventory. A reduction in our level of net sales or the rate of growth of our net sales from their current levels would mean that the rate at which we are able to convert our inventory into cash would decrease.”

Balance sheet charts

The value of overseas assets and liabilities is affected by exchange rate movements, and for 2014 both will be lower than otherwise due to the higher dollar. The lower Ruble will have had an effect on asset values, particularly on Property, plant, and equipment, net. From an accounting perspective, the translation adjustments which dominated the negative Other Comprehensive Income in 2014 would have the effect of pushing asset values down (but that was more than offset by income pulling the value up). The translation adjustments imply that overseas assets are bigger than overseas liabilities. That’s to be expected as the overall assets are bigger than liabilities, and it’s common for an international company with head office costs in the U.S. to have its liabilities concentrated there.

The unrealized gain on derivatives in 2014 was only $172 thousand, and I found no indication of a realized gain on currency hedges in 2014. IPG report Cash Flow Hedges but they were for fixing interest rates, not hedging currencies. From the 10-K for 2014 –

    “We have no foreign currency derivative instrument hedges as of December 31, 2014 . We will continue to analyze our exposure to currency exchange rate fluctuations and may engage in financial hedging techniques in the future to attempt to minimize the effect of these potential fluctuations.”

The 10-Q for Q1 2015 has a similar statement with “We have no foreign currency derivative instrument hedges as of March 31, 2015 .”

IPG assets

IPG assets per share

IPG assets per cent of total

IPG liabilities and equity

Regarding the note in the graphic above, in the balance sheet spreadsheet at the end, the equity is called “Total IPG Photonics Corporation stockholders’ equity”. The name is used in 10-Ks for 2009 to 2014. My calculation agrees with Total liabilities for 2012 to 2014, but is greater than stated total liabilities for 2011 as my calculation includes minority interests. In 2010 the term “Total liabilities” was used but not on the balance sheet, and in 2006 the term was only used in connection with a covenant ratio.

There were many claims on assets in 2005, including series A, B and D, warrants, Notes receivable from stockholders, and Deferred compensation. Most of those items were gone by 2006, but I still preferred to use my simplification so I could take the charts back to 2005. The term “non-stockholder claims on assets” would have been more accurate, as my “calculated liabilities” includes liabilities, minority interests, and the variety of claims on the 2005 balance sheet.

IPG liabilities and equity per share

IPG liabilities cash and current assets

IPG liabilities as percent of cash


I don’t repeat the spreadsheet for cash flow growth which I’ve shown above. The only omission I know about is for the “Logarithmic chart, base 2, of sales and profit” (before the title “Comprehensive income charts”, above), where I don’t show the results or formulas of the logarithmic functions. The logarithmic formulas all have this format, with only the cell address varying –


IPG results to Q1 2015 spread

IPG cash from ops and into investment - spread2

IPG Photonics sales costs and profit - spread

IPG Photonics sales costs and profit - sign adj - spread

IPG Photonics sales costs and profit - sign adj - formulas

IPG Photonics sales costs and profit sign adj percent - spread

IPG Photonics sales costs and profit sign adj percent - formulas

IPG comprehensive income - spread

IPG comprehensive income - formulas

IPG sales breakdowns spread

IPG DSO days inventory - sales income and CFO - spread

IPG balance sheet spread

That’s all.

DISCLAIMER: Your investment is your responsibility. It is your responsibility to check all material facts before making an investment decision. All investments involve different degrees of risk. You should be aware of your risk tolerance level and financial situations at all times. Furthermore, you should read all transaction confirmations, monthly, and year-end statements. Read any and all prospectuses carefully before making any investment decisions. You are free at all times to accept or reject all investment recommendations made by the author of this blog. All Advice on this blog is subject to market risk and may result in the entire loss of the reader’s investment. Please understand that any losses are attributed to market forces beyond the control or prediction of the author. As you know, a recommendation, which you are free to accept or reject, is not a guarantee for the successful performance of an investment.

IPG Photonics’ cutting edge

Disclosure – I’m long IPG Photonics Corporation (IPGP)

The Q1 earnings call has encouraging information about technological advance. I’ve described the highlights and made some comments, but I recommend reading the original – “IPG Photonics (IPGP) Valentin P. Gapontsev on Q1 2015 Results – Earnings Call Transcript” Apr. 28, 2015 (www.seekingalpha.com). I’ve mostly quoted from the prepared remarks which can be downloaded from IPG’s site.

Technology highlights

Cutting thick metals (2D)

    – steel, aluminum, titanium, tungsten, and others
    – thickness 3 to 10 centimeter
    – the package includes high grade cutting tables 3 to 12 meters long
    – new generation of IPG 10 kW to 15 kW lasers
    – unique cutting heads for up to 20 kW optical power

Cutting highly reflective metals (2D)

    – copper, gold etc.
    – new kW class single mode green fiber lasers

Welding thick metals (developed by the Russian subsidiary)

    – steel (up to 10 cm)
    – titanium (up to 5 cm)
    – other metals (not specified)

Cutting pipes

    – first high quality pipe cutting machine
    – installed in customer sites

“5D” acquisition

    – “5D” probably means the laser can be pointed in any direction from any position, within limits (as you could for a hand-held laser pointer)
    – a 76% interest acquired in a small 25 years old Belarusian technology company serving the Russian market
    – develops tools and controls for large-scale high-power 5D laser systems
    – focus on cutting, welding, cladding and prototyping
    – will use IPG laser sources for applications with little laser penetration currently
    – integrates laser sources, CNC, software, and electrical controls and drive systems, and uses specialized optical heads

Technically, 5D might mean five “degrees of freedom” – the normal three dimensions for position, plus two degrees of rotation, as in a tank where the turret rotates and the barrel on the turret can tilt, allowing the barrel to have any orientation (within about a hemisphere). It’s possible for “5D” to mean control of five parameters which are not all for position and orientation, find “Superman memory crystal” below.

Further to “Welding thick metals” –

    “… On the basis of these results, we have started some very large scale projects in the oil industry, large bridge sections and other similar products manufacturers. For example, in Q1 we achieved good progress in the development of mobile machine for oil pipe casing welding. The direct tests of our equipment in the field, on the well drilling stations, should start next month.” (the prepared remarks)

3D printing

Sales of fiber lasers for additive manufacturing, which includes 3D printing, were over 60% above the year-ago quarter.

From the prepared remarks –

    “Notwithstanding slow growth of the economy in the Eurozone, European sales grew 15% year-over-year to $65.1 million, driven by even stronger growth in Germany from sales to the automobile and 3-D printing industries, partially offset by weakness in Russia related to the economic environment.”

    “We expect demand for 3D printing applications to continue to grow.”

Niche and customized systems

A car-maker will usually want to make cars rather than put resources into developing systems built around lasers and the associated optics. The same applies to many industrial customers. A systems integrator could develop systems for them, but integrators can be too slow or too conservative regarding new applications. Rather than let such opportunities pass by, that’s the kind of case where IPG consider developing a complete solution including hardware and software.The CEO made it clear that they will not compete with the customer (meaning systems integrators or OEMs, as they clearly aren’t going to make cars, planes etc.).

Cutting thick metal with higher power (10 Kw) lasers is such a case. Higher power naturally leads to faster cutting, and the problem to be solved when developing a high power cutting system is in maintaining quality (as well as safety and reliability). The CEO believes 100 of the cutting machines could be sold in 2015. IPG are willing to sell all the parts a system integrator would need, including the lasers and the optical heads.

The way I see it, if the makers of cutting systems don’t make high power systems, they will lose potential sales to IPG. There’s no guarantee that integrators will put IPG lasers in their systems – they might buy IPG for the specification or because the lasers are proved for the application, but they might be wary if they see IPG as a competitor. IMO it’s likely that either system integrators will follow IPG’s lead using IPG’s lasers, or IPG will realize the opportunity to sell their own systems. If IPG keep having to show the way, they will be more of a threat to OEMs, but they will want to underplay the threat.

Paint removal is a different example. There was a clear need for paint removal by laser, for aircraft. The technical challenge must have been considerable, because the solution involved IPG working with many partners for about a decade. The resulting system is mobile, and as well as a laser includes a robot and “very complicated scanning system software” (from the Seeking Alpha transcript).

    “Now, the long-term project is turning from qualification to the mass deployment phase, and IPG fiber lasers are playing the role of an excellent engine there. Recently we received a request from a leading customer to become a key supplier of complete systems.” (the prepared remarks)

From the Q&A in the earnings call transcript on Seeking Alpha –

    “we found that total market for paint removal, it’s more – only in the U.S. only in Air Force more than $800 million per year, but total worldwide more than $3.5 billion per year. Up to now, this is how this removal making by chemical and other, … Laser technology allow to simplify dramatically with this solution make much more perfect,”

I don’t know how much of that could be revenue for IPG. For context, 2014 net sales were $769.8 million.

    “now a situation than it was really going from developed, made, and qualified for many application and going native for mass production. Our customer – leading customer who can – who will be able to produce and supply highest quality of such volume, such equipment …”

    “But we develop as much a better pulsed laser – multi-kilowatt pulsed laser, not CW, they open now still a new opportunity for this. So it’s really now the time, new phase when really the demand will grow very fast. It’s only still – they don’t have customer, don’t have real good quality manufacturer. We’re ready to take such position.”

Paint removal is likely to be a commercial success for the customer as well as IPG, demonstrating the potential reward of involvement in bringing IPG’s laser technology to new applications.


Lidar means ‘LIght Detection And Ranging’, a kind of laser-based version of radar. A laser is scanned ahead, and various kinds of backscattering can then be detected. Depending on the application and the design, the backscattering can be processed to infer the position and velocity of a vehicle, the movement of air, and many other quantities involving position and movement.

Following the quote about paint stripping in the prepared remarks –

    “Other large volume potential projects include fiber laser lidar sensors for driver-free vehicles and many other applications.”

Driverless trucks from Komatsu have been used in remote mines since 2008, apparently using radar rather than lidar.

This piece about the difficulty of writing the software confirms that lidar is a key technology for driverless vehicles on the road.

Wikipedia lists a variety of applications for lidar, including agriculture, space flight, mapping the biodiversity of redwood forests, detecting air turbulence, and the “speed guns” used by the police.

Zinc brazing

Car makers have changed from coating steel chemically to using hot melted zinc. That may have been for environmental or safety reasons, because the hot zinc process has variable quality resulting in too many defective cars. IPG now have a brazing system which solves the problem. Brazing is like welding except that two different metals are joined. Like welding, and unlike soldering, both metals need to melt to get a strong mechanical join. The application here is coating which is obviously different to the usual joining of metal pieces. The brazing system has passed tests, and the CEO reports high interest and expects quick market penetration. I find that plausible because the problem is new rather than something the industry has learned to live with. From the prepared remarks –

    “The elegant, patent-pending IPG solution resolves very significant technical limitations of other processes. Currently we are finishing successful production tests with one of the largest car manufacturers and we expect to start mass deployment in the second half of the year.”


The fast likely take-up of IPG’s zinc brazing technology is in contrast to the seam-stepper welding technology. The zinc brazing was started later and looks likely to achieve substantial sales earlier. The seam-stepper has the advantage of providing laser welding without requiring an expensive laser-safety cell, a kind of light-tight hut with a laser and usually a robot in it. It’s on the 5th generation now, without substantial sales. The difference is that car-makers were under pressure to find a better coating technology, and there’s no such pressure to drive seam-stepper sales. The CEO is still very hopeful, and so am I, but it shows how commercialization can take time.

BTW, the laser-safety cell plus robot plus laser is the kind of area where IPG are unlikely to compete, as it is well served and competition from IPG would probably alienate OEM customers.

Developement, commercialization and time

Car-makers are conservative. In 2013, the CEO of Ford admitted that the pace of innovation in the industry had been too slow, before promising to put that right at Ford, mostly in the area of digital technology. SatNav was not developed by the auto-makers and even today many drivers prefer to use a smartphone to built-in StaNav when it’s available. The top R&D spender in any industry in 2014 was Volkswagen, with Toyota 7th, but Tesla was the only auto-maker in the top ten innovators (by recognition, as it’s hard to quantify innovation) (see here).

    “Many of our target markets, such as the automotive, machine tool and other manufacturing, communications and medical industries, have historically adopted new technologies slowly. These markets often require long test and qualification periods or lengthy government approval processes before adopting new technologies.” (10-K for 2014)

The long period of development of the paint removal technology (for aircraft) was simply because it took that long to develop. Sales for 3D printing took a long time to grow to a level worth commenting on in an earnings call. The examples indicate that conservatism about new technology, development time, and time for the market and sales to ramp up, can all mean a long time before commercial success.

Previous tech concerns

I have had various concerns about technology which could impact IPG. These tended to be low probability threats from emerging technology, at the research stage or being commercialized by small companies, rather than incremental advances from established competitors. Revisting the possible threats shows that either they did not develop, or IPG have been able to counter them. IMO the ability to avoid being leapfrogged by technology is crucial whenever a company is in a technology race.

    Direct diode technology

Direct diode seemed like a possible threat to IPG due to the advantages claimed, of high brightness and high electrical efficiency. Two small companies made direct diode lasers, and now IPG, Coherent and others make them. The minnows are TeraDiode and DirectPhotonics. TeraDiode received contracts and Small Business Innovation Research Awards from the Department of Defense in 2011. The threat in materials processing dropped when IPG announced a range of lasers with over 45% electrical efficiency, clarified to wall plug efficiency above 45% in the Q1 2014 earnings call. In the same call it was stated that production costs of the range were more than 50% lower than for the IPG lasers they replaced.

For direct diode lasers –

    TeraDiode claim 40% wall plug efficiency,
    Coherent claim Greater than 45% electrical to optical efficiency. Electrical to optical efficiency ought to be the same as wall plug efficiency, but I have to wonder why they don’t use the same term as other laser-makers.
    The only clue I found for the efficiency of Trumpf’s TruDiode range of direct diode lasers is this general statement in a press release from October 2014 – “The special advantage of the diode direct laser is its relatively high efficiency level – as much as 40 percent.”
    IPG claim 50% wall plug efficiency.

    TeraDiode’s highest power is 4 kW (with a prototype up to 8 kW),
    Coherent’s highest power direct diode lasers are 10 kW,
    Trumpf’s TruDiode range goes up to 6 kW laser power,
    and IPG’s direct diode lasers only go up to 2 kW.

IPG lead in efficiency but trail in power. I don’t see direct diode laser technology as a serious threat to IPG.

The power is enough for many applications, but for some comparison, IPG have sold 100 kW fiber lasers since 2013 (finding IPG’s most powerful laser is not easy – the site lacks a button labelled “I just want to zap something”).

Direct Photonics received their first order in 2013 for 2 kW lasers and generally seem non-threatening.

As for all of IPG’s lasers, the company’s direct diode lasers use single emitters –

    “Another key element of our technology platform is that we use multiple multi-mode, or broad area, single-emitter diodes rather than diode bars or stacks as a pump source. We believe that multi-mode single-emitter diodes are the most efficient and reliable pumping source presently available, surpassing diode bars and stacks in efficiency, brightness and reliability. Single-emitter diodes have substantially reduced cooling requirements and typically have estimated lifetimes of more than 100,000 hours at high operating currents, compared to typical lifetimes of up to 10,000 to 20,000 hours for diode bars.” (10-K for 2014)

TeraDiode and most laser-makers most of the time seem to use the diode bars.

This is informative about direct diode lasers, and has some discussion of the relative merits of using single-emitters versus diode bars in them – “PHOTONIC FRONTIERS: DIRECT LASER DIODES: Making direct laser diodes shine more brightly” by Jeff Hecht, 03/01/2013 (laserfocusworld.com). When “fiber” is mentioned it’s not the active fiber in fiber lasers.

To show that IPG are not the only users of single-emitter diodes, number 9 in this list is a direct diode laser from Raycus which uses single-emitters – “Top 9 laser products of 2014” Dec 17, 2014 (ofweek.com). Trumpf are in the list with a short pulse (800 femtosecond) laser, and IPG are not in the list.

Slightly off-topic, I said “IPG announced a range of lasers with over 45% electrical efficiency, clarified to wall plug efficiency above 45% in the Q1 2014 earnings call.”. Trumpf don’t give the efficiency of their limited TruFiber fiber laser range, and they say this about their disk lasers – “The latest generation of diode-pumped lasers have an efficiency of over 30%”.

    Resistance spot welding of aluminum

In the Q2 2012 earnings call the CFO said that aluminum and harder steel used in the auto industry was difficult for resistance spot welding, and fiber lasers were well suited for welding those metals.

By September 2012 General Motors had developed a new resistance spot welding process that worked for aluminum, posing a threat to the use of fiber lasers for welding in the auto industry.

In the Q1 2014 earnings call the CEO stated that the seam stepper could weld aluminum.

A variant of IPG’s zinc brazing system has some potential for welding aluminum. The system was described as the “new one-of-a-kind 3-beam fiber laser system for brazing of zinc coated steel parts in the automobile industry”, and IPG said this about it –

    “The other version of the same system looks very hopeful for an essential increase in aluminum welding quality. The growing use of aluminum in autos and other industries saves weight and increases fuel economy. So, aluminum welding continues to be a strong opportunity for us.” (the prepared remarks)

That’s in addition to the welding technology developed by the Russian subsidiary (listed near the top, with steel, titanium and “other metals”).

Hopefully IPG will be able to incorporate the advances in a new version of the seam-stepper. It’s possible that new welding techniques have delayed the uptake of laser welding in the auto industry, and it may be a factor in the slow uptake of the seam stepper, but with IPG’s advances in welding metals, time is on the side of IPG.


Research into HOFGLAS (Hollow core Optically pumped Fiber Gas LASers) a few years ago showed some promise of overcoming the scattering and thermal lensing which increases in an active fiber as more power is put into it. Googling found nothing relevant in the past year except for an academic paper – “CW hollow-core optically pumped I2 fiber gas laser”, which you can buy here if you’re really keen.

Hollow fiber is an obvious application for telecoms, because light travels fastest through a vacuum, a little slower through air, and 30–40% slower through glass than through air. That might not affect which laser is best for shining into the fiber.


Vertical Cavity Surface-Emitting Lasers (VCSELs) are two-dimensional arrays of laser diodes on the same chip. If these become good enough, it would be hard for IPG to adopt the technology, because they differentiate themselves by using only their own discrete ‘single-emitter’ laser diodes.

The problem with a VCSEL is that it’s flat and the radiation is perpendicular to the surface, so the area that can be cooled is about the same as the cross-section of the beam. Increasing the power is not a problem if you increase the emitting area by the same proportion, but the area of the beam cross section will also increase by the same proportion. For a diode where light comes out of the side, the area that can be cooled is bigger than the cross-section of the beam. The highest continuous wave (CW) output power reported on Wikipedia was only 200 W, in 2007. A previous record was achieved using a diamond heat sink. Heat disappation seems to be an engineering problem where breakthroughs don’t happen.

VCSELs produce a large-cross-section single-mode optical beam, which diverges less than the beam from standard ‘edge-emitting’ laser diodes. That’s an advantage when you want to get light into an optical fiber, and VCSELs are used in the optics-based Gigabit Ethernet. They might have the same advantage for pumping a fiber laser, but I could not find good evidence.

Wikipedia lists applications including pumping of solid-state lasers and fiber lasers, wrinkle removal, and atomic clocks. They include various materials processing applications (excluding welding), but I doubt that VCSELs will account for much market share, short of an unexpected breakthrough. See also “VCSELS for Manufacturing: High-power VCSEL arrays make ideal industrial heating systems“12/10/2014 (laserfocusworld.com).

There’s a paper from 2013 called “High Peak Power VCSELs in Short Range LIDAR Applications” which you should be able to get by googling the title. It was about a military application, detecting flying shrapnel, and it might not be as suitable for lidar in driverless cars, where IPG’s CEO claimed potential for fiber lasers.

There’s an optically-pumped variant called “VECSEL” (Vertical External-cavity Surface-emitting Lasers) which have high beam quality, and they might be able to produce more power than VCSELs, though cooling is still a problem. Wikipedia give industrial machining as an application, and mention “high power and efficiency”. VECSELs can be pumped by diode bars with low beam quality and still produce a high quality beam, but other optically pumped lasers turn the output of cheap laser diodes into a high quality output beam, including fiber according to the University of Southampton (find “cheap”).

    Digital lasers

‘Digital lasers’ represent a low-probability high-impact threat. In an old-style laser with light bouncing between two reflective surfaces, one of which is an opaque mirror, instead of the normal mirror there’s an LCD image. Changing the image changes the characteristics of the laser. Being able to change the image will not increase the power or efficiency, and if it isn’t feasible to apply the same idea to fiber lasers (where reflection is between Bragg gratings in the fiber), I don’t see much threat. If that proves possible, increased versatility reduces the number of models needed for a given set of applications. While the impact of fewer models could be huge, I can’t predict the implications for IPG’s income. I wrote about digital lasers in “IPG Photonics – growth, cash, markets and technology” September 27, 2013 (find “Digital lasers”), along with other exotic technology under “Advances and applications”.

It might be possible to apply the technique to disk lasers, which Trumpf still make, but the impact of that involves three fairly imponderable factors – the potential of digital lasers, the ease of applying the technology to disk lasers, and the merits and drawbacks of disk lasers compared to fiber. To see the advantages Trumpf claim for disk, search for the PDF “IMTS High power solid state lasers and their applications” and find “Why did Trumpf choose the disk laser architecture”. One claimed advantage is modularity. A key advantage of fiber is the ease of cooling, see Wikipedia for more. VECSELs incorporate an external mirror, and applying the digital laser technology to them might be easier.

A search found nothing new about digital lasers, just a July 2014 rehash of the old story, which I think is a bit sad. I don’t believe the possible threat from digital lasers is likely.

My conclusion from the review is that a technological advance with the potential to erode IPG’s sales is not likely to be a good reason for much pessimism, although I’d still rather know about the advances.

2015 Prism Awards

Winners named for 2015 Prism Awards for Photonics Innovation” 12 February 2015 (spie.org) – IPG won in the “Industrial Lasers” category, for their GLPN-500-R, which was liked for being a fiber laser with output in the visible spectrum (green). It’s a single-mode laser, meaning a pure single frequency and highly coherent
(with a long coherence length). Applications include welding and cutting highly-reflective metals (one of the highlights at the start), and solar cell manufacturing.

I counted nine categories (with just one winner in each). Other winners’ applications included the 3D printing of optical components, the measurement of bacteria in fluids at low concentration, and a rugged spectrometer the size of a fingertip. In 2013, TeraDiode beat IPG in the Industrial Lasers category, and as I’ve explained, IPG are now ahead in wall plug efficiency but behind in power for direct diode lasers. The 2014 “Industrial Lasers” winner was V-Gen for a versatile fiber laser which exceeded others on peak power, pulse energy and narrowness of pulsewidth, and was suitable for materials processing (although welding was not listed), for a very wide variety of materials.

The awards are a reminder that IPG are not the only innovator in materials processing or in other fields of laser technology.

There’s a section about “New laser technology and applications” which I put near the end because IMO the possible threats aren’t all that serious.

Competitors will have the scale for vertical integration

The closer competitors get to achieving IPG’s level of vertical integration, the more IPG rely on innovation to stay ahead or at least stay differentiated (if competitors innovate successfully in other areas). Size is a factor in the ability to achieve vertical integration. The following charts are only meant to give a rough idea of IPG’s relative size. The first chart is only for the companies in the Industrial Laser Index on Industrial Laser Solutions’ site.

IPG relative size

If you want to research the companies you can use these links to Seeking Alpha – COHR, ESIO, GSIG, IIVI, IPGP, JDSU, NEWP, ORBK, RSTI, UTEK.

Trumpf (a private German company) is not included in the index, and I’ve included them in the next chart. Trumpf also have a large machine tools business, and I have not seen figures for only the laser segment. (They also started a bank recently.)

IPG relative size inc Trumpf

Most of IPG’s industrial laser competitors will be less concentrated in materials processing, industrial lasers and fiber lasers. Because the charts only give a rough guide, I also give other opinions about which companies count.

This piece – “Laser Processing Market Expected to Reach USD 17.26 Billion in 2020 Globally” Sep 24, 2014 (transparencymarketresearch.com), lists companies in “laser processing”, with Trumpf first and IPG the last of nine named companies before “and others”.

This looks more relevant, and the order looks purely alphabetical – “Research and Markets: Global Industrial Laser Market 2015-2019 with Coherent, IPG Photonics, Rofin-Sinar Technologies & Trumpf Group Dominating” Jan 27, 2015 (reuters.com).

This page is also on transparencymarketresearch.com, it has a basic description of the high power laser market, and lists IPG Photonics first out of twenty.

I see no chance of IPG achieving a market share so big that competitors won’t have the scale necessary for vertical integration. The markets are expanding and diverse, and while strong in materials processing, IPG can’t quickly squeeze peers out of medical and other areas (see below, about defense). A good year for IPG does not even mean that Trumpf have to have a bad year.

Vertical integration and innovation

    Vertical integration by Trumpf

About two years ago I looked into Trumpf’s claim of being vertically integrated (here, find “two lists of in-house production”). I found they were probably not as vertically integrated as IPG in fiber laser production, although the evidence was not strong and was open to interpretation. IPG were likely to have a lead in vertical integration for fiber because for a long time there was scepticism about fiber lasers (which IPG pioneered), and competitors were late to wake up to their potential. Trumpf own SPI Lasers, and SPI acquired JK Lasers on April 15, 2015. SPI say about JK

    “one of the world’s leading manufacturers of high-power Fiber Lasers for industrial use”

    “bringing improvements in both experience and expertise to SPI Lasers, creating a more versatile organisation, with enhanced vertical integration.”


    “their acquisition helps SPI Lasers to strengthen their position as a leader in the Fiber Laser market.”

Trumpf can only claim to be “a leader” in fiber, because IPG are “the leader”.

I’m not particularly impressed by JK Lasers’ range. The “High Power Fiber Lasers” are for 1 kW to 4 kW (Average Output Power), and while “Energy efficient” is claimed, I could not see a figure on this page or on the datasheet you can download. They might be good on other parameters.

SPI’s maximum power for fiber lasers (pre-acquisition) seems to be 1 kW, and to see the specifications you need to register or log in. Trumpf also have various lasers on their us.trumpf.com site.

    Vertical integration in China

China is catching up in lasers. The PDF “Chinese Laser Technology, Industry and Market” by Xiao Zhu and Jiayu Wang, 12 Dec 2014 (onlinelibrary.wiley.com) describes the advance of the Chinese laser industry from small beginnings. The authors claim that the first 10 kW fiber laser made in China ‘last year’ (2013) was also the second in the world (presumably, the second company in the world to achieve that). The laser diodes and active fiber were still not made in China, but much was being invested by the state and big companies in a strategic effort, “aiming to achieve vertical integration as IPG.”.

The PDF about China describes how the state is backing ‘blue sky’ research while the companies are pushing up the power and making other incremental developments. That’s quite normal, and there has always been some risk that a big ‘blue sky’ development somewhere in the world might not be accessable to IPG. I believe the risk is greater in China. Firms will be favored with the fruits of research depending on how Chinese they are or how well they are politically connected. There’s a risk that laser companies could be given cheap loans for investment and survival, as happened with solar photovoltaic modules. Chinese solar production crashed world prices and caused a variety of tariffs and protectionist measures around the world, but the barriers to commoditization seem higher for lasers, due to the high and increasing diversity of applications and the lasers required for them. Customized laser systems obviously require working with the customer rather than rolling vast amounts off a production line and selling below cost. IPG’s innovation and diversification out of mainstream industrial materials processing is probably the best defense.

Trumpf’s Annual Report 2013/14 has some comment about China. The country entered the mechanical engineering sector in 2008 with “ultra-low-end products” and are now the third largest machine exporting country in the world. Trumpf expect China’s laser industry to follow a similar path. A paragraph is headed “Cooperating instead of competing”, about how they acquired CNC Machine Company Ltd. (JFY), and needed to reconcile the mature sophisticated German approach and China’s “keep it simple” attitude. Trumpf say Chinese customers are highly loyal, and lasers sold by JFY are probably the result of Trumpf using JFY as a channel to exploit the customer loyalty.

    Cheaper laser diodes reduce IPG’s cost advantage

The cost of laser diodes has fallen dramatically, and the cheaper diodes become relative to other costs, the less IPG’s diode cost advantage matters. The PDF “Master of metal” on Coherent, Inc’s site mentions “price” in connection with laser diodes a few times. A vice chairman of Trumpf is quoted as saying he doesn’t think the price will come down as fast now that the cost of diodes is not such a significant part of the cost of a laser. I’d say that even if the general price trends down, the highest power diodes could stay expensive if IPG maintain a lead, although I don’t have facts to support that. Find “Czech Republic” below for a project with a vast amount of laser diode power.

Having their own diode production will still contribute to IPG’s ability to design better lasers, but a big chunk of the advantage from vertical integration will have disappeared, at least for diode powers where competitors have scale. That’s my opinion, and they ought to know more at IPG. Here’s what they say, from “IPG Photonics’ (IPGP) CEO Valentin Gapontsev on Q3 2014 Results – Earnings Call Transcript” Oct. 28, 2014 (www.seekingalpha.com)

The CFO –

    “… I think that the cost basis of diode manufacturers in the market is still substantially higher than IPG. IPG benefits … from technological advantages around yields, automation, simplicity of package design … I don’t know exactly where the manufacturing cost of the competitors is, but it is probably at least — their manufacturing cost may be 300% higher than ours and the price that we see in the market — or hear about in the market is still five times higher than our diode manufacturing costs. …”

The CEO –

    “We don’t see serious diode competition. It is only the (indiscernible) who produce diode chips and package outside. But it also increases the cost of final product … we increase each year the volume by 40% the last two years, per year. So it is — nobody warrants with such volumes and so on to reach such volumes should be enormous contributor to time and investment.”

Innovation and Russia

IPG are keen to emphasize the advantages of vertical integration. IMO they say less about the advantage of low cost production in Russia, which is bigger when the Ruble is low. Successful innovation reduces the dependence on low cost production in Russia, but much of the innovation originates in Russia.

IPG benefit from photonics expertise in Russia and Belarus, and have been able to acquire Russian companies and the controlling interest in the “5D” Belarusian company. To some extent that may offset the Chinese government’s willingness to support their laser industry. Europe gives a 20% subsidy to approved research, see “Horizon 2020 to splash €700 m on photonics research and development” by Matthew Peach, 12 Dec 2013 (optics.org). IPG might not get the full benefit of Russian research due to the U.S. domicile of the holding company, and that might apply particularly to high power lasers with potential in directed-energy weapons as well as industrial uses.

New laser technology and applications

I have to admit that a few of these are not directly commercially relevant, but they show some of the diversity in laser technology and applications.

New laser could upgrade the images in tomorrow’s technology” by Jim Shelton, January 19, 2015 (news.yale.edu). The tech is called “chaotic cavity laser” and it could apply to imaging from microscopes to holographs. It solves the problem of being as bright as a laser but without the speckle. Light from LEDs don’t have the speckle but aren’t bright enough. The chaotic cavities are electrically pumped semiconductors, as are LED’s, VCSELs and laser diodes. IPG are not big in the imaging area, although they have lasers for projection in 3D cinemas.

Metals Now Water-Repellent With New Laser Technology” by Jenna Iacurci, Jan 21, 2015 (natureworldnews.com). A fine pattern is engraved in the metal’s surface, and the result is more water-repellent than teflon but the process is slow. I can’t help wondering if the surface would make torpedos go faster.

Laser technology offers new option to treat epilepsy” by Leslie Hill, Mar. 12, 2015 (vanderbilt.edu). “Ablate your brain” might not sound appealing, but it seems to be less invasive than the current surgical option.

Northwestern Scientists Develop First Liquid Nanolaser” by Megan Fellman, April 24, 2015 (northwestern.edu). Instead of bouncing light between two mirrors, light bounces between tiny reflective particles of gold. Like the ‘lab on a chip’, it has microfluidic channels, and flowing a different liquid into the channels changes the characteristics of the laser. The gold nanoparticles are in a fixed array, presumably fixed to the surface of the channels so they don’t move with the fluid (a diagram would have been nice). One possible application is in medical diagnostics. (In a fiber laser, reflection occurs between Bragg gratings in the fiber, near the ends.)

This one isn’t cutting edge, but when lasers replace chemicals it’s environmentally friendly – “New York Peace Monument At Point Park Restored With Laser Technology” Monday, April 20, 2015 (chattanoogan.com).

This is about the French version of America’s National Ignition Facility – “EXCEPTIONAL TECHNOLOGY FOR THE LASER MEGAJOULE FACILITY” by thierry lucas – Publié le 09 avril 2015. The text is in English but some readers might need to know that “Fermer” means “Close”. I’m sure “Les cookies” needs no explanation.

European x-ray free electron laser” (wikipedia.org)

This one is being constructed in the Czech Republic. I don’t know what it is with Europeans and high energy beams lately. “Team deploys world’s highest peak-power laser diode arrays” Mar 12, 2015 (phys.org).

The man who wants to control the weather with lasers” by Jacopo Prisco, for CNN, April 24, 2015 (cnn.com). Conventional cloud seeding puts chemicals into the environment. Lasers provide a chemical-free alternative, but require short bursts of extremely high energy. I have not found an explanation of how lasers create droplets in clouds.

This one includes cloud brightening – “Scientists Propose Using Lasers to Fight Global Warming From Space” by Brian Merchant, Senior Editor, August 22, 2014 (vice.com).

Trumpf’s Annual Report for 2013/14 (15 Mb PDF) includes a section on invisibility (PDF page 60). This is based on a photonic metamaterial which bends light around an object and the light emerges on its original path, as if nothing had been in the way. There’s an interview with the physicist Tolga Ergin, and no technology from Trumpf is mentioned.

This isn’t new but I can’t leave out Superman memory crystal – 5D optical memory in glass could record the last evidence of civilization Jul 09, 2013 (phys.org). In this case, the five “dimensions” are 3 for position, 1 for orientation, and 1 for size, presumably for some feature written into the glass.

For no good reason, and it’s far from being battle-ready – “Laser weapon blasts through truck” March 07, 2015 (foxnews.com).

International Year of Light

2015 is the United Nations’ International Year of Light and Light-based Technologies. The effort is intended to raise awareness, and much of the focus is on the history of optics. The “Economic Impact” page looks low-priority, recycling old projections with some future left, which you can download. There’s a claim that growth in the world’s optics industries was twice as fast as world GDP growth from 2005 to 2010. The “Year of Light” might encourage careers in photonics.

About the main sources

Where I’ve drawn on the prepared remarks and the Q&A in the Seeking Alpha transcript, I’ve only given highlights. It’s worth reading those sources, which have more detail including applications I have not mentioned up to now – silicon polycrystal films annealing, and the manufacture of train cars and steel.

With thanks to Seeking Alpha for their policy regarding quoting from transcripts, which you can find at the end of the transcript. I’ve quoted 173 words from the Q1 2015 transcript and 149 words from Q3 2014, for a total of 332 words.

Thank you for reading this.

[ I added data for Trumpf’s direct diode lasers on May 10, 2015 ]

DISCLAIMER: Your investment is your responsibility. It is your responsibility to check all material facts before making an investment decision. All investments involve different degrees of risk. You should be aware of your risk tolerance level and financial situations at all times. Furthermore, you should read all transaction confirmations, monthly, and year-end statements. Read any and all prospectuses carefully before making any investment decisions. You are free at all times to accept or reject all investment recommendations made by the author of this blog. All Advice on this blog is subject to market risk and may result in the entire loss of the reader’s investment. Please understand that any losses are attributed to market forces beyond the control or prediction of the author. As you know, a recommendation, which you are free to accept or reject, is not a guarantee for the successful performance of an investment.

Gilead Sciences – a dose of information

Disclosure: I’m long Gilead Sciences, Inc. (GILD).

Share price as at April 1, 2015: $97.72.

Contentious profile

Gilead say they are a “… research-based biopharmaceutical company that discovers, develops and commercializes innovative medicines in areas of unmet medical need.” (from the 10-K). Pure “bio” companies can make things like stem cells or complex proteins that are hard for anyone else to make (see Biosimilar on Wikipedia). Producers in India, China and Bangladesh are capable of making Gilead’s big sellers or the intermediates they can be made from. Gilead have the same reliance on patents as any other pharma innovator, and similar risk, except for the unusual attack from AbbVie’s controversial combination-finding model.

About this piece

Investors who are new to Gilead might like to read from “Litigation regarding Sofosbuvir” (below) first, to see if they are comfortable with the risk and with their ability to assess it.

My simple explanations may bring more pain than joy to well informed readers, who might prefer “Gilead Sciences – the charts” (wordpress.com), where I’ve cut nearly all the text.

I cover many aspects of the business, with a lot about hepatitis C but not much about HIV.

I start with a table and chart for customer concentration, then break down revenue by geography, type and product, which leads into product descriptions, the pipeline, and more.

Customer concentration

Gilead customers over 10pc rev - spread

Gilead customers over 10pc rev

Revenue by geography

Gilead revenue by geography - spread

Gilead revenue by geography

Gilead revenue by geography percent

Revenue by type

This is overwhelmingly product sales. The other category is Royalty, contract and other revenues.

Gilead rev by type - spread

Gilead rev by type

Revenue by product

Gilead product breakdown spread

(The spreadsheet formulas are shown here.)

Gilead product pie detail

Gilead product pie type

Harvoni was only on sale for a short time in 2014, with approval from the FDA in October 2014 and from the European Commission in November 2014. Quoting from “Gilead Sciences’ (GILD) CEO John Martin on Q4 2014 Results – Earnings Call Transcript” Feb. 3, 2015 (www.seekingalpha.com) –

    “prescription data at year-end indicate that for each Sovaldi patient, three patients started therapy with Harvoni.”

It’s hard to estimate 2015 sales of Harvoni by extrapolating from the short period of sales in 2014, partly because –

    “Although after the launch of Harvoni we saw payor restrictions increasingly in place across all patient types and especially for those with lower fibrosis scores.” (the Seeking Alpha transcript, linked to above)

and there has been news in 2015 which affects price and volume. Payor restrictions have been eased, but in return for lower pricing. If you want to estimate 2015 sales of Harvoni, you may be better off looking at the weekly prescriptions and multiplying by the average price, if you can estimate it, but the prescription data I found is U.S. only and might not catch every prescription.

In the two pie charts that follow, I set Harvoni sales equal to Sovaldi sales in 2014, to give a view of the product concentration which does not grossly under-represent Harvoni. The simple kludge is not intended as a projection, or as an adjustment to 2014 results. Some Harvoni sales will replace Sovaldi sales, and the charts take no account of that.

Gilead product pie detail extra Harvoni

Gilead product pie type extra Harvoni

Gilead’s products

I’ve quoted selectively from a list on page 6 of the 10-K PDF. Lots of crucial info is omitted to keep the length down. I put in the percent of Total product sales I calculated, when the sales of the product were disclosed.


• 4.89% ~ Stribild is an oral formulation dosed once a day for the treatment of HIV-1 infection in treatment-naive adults. Stribild is our third complete single tablet regimen for the treatment of HIV and is a fixed-dose combination of our antiretroviral medications, Vitekta, Tybost, Viread® and Emtriva® (emtricitabine).
• 5.02% ~ Complera/Eviplera is an oral formulation dosed once a day for the treatment of HIV-1 infection in adults.
• 14.18% ~ Atripla is an oral formulation dosed once a day for the treatment of HIV infection in adults. Atripla is our first single tablet regimen for HIV intended as a stand-alone therapy or in combination with other antiretrovirals.
• 13.65% ~ Truvada® (emtricitabine and tenofovir disoproxil fumarate) is an oral formulation dosed once a day as part of combination therapy to treat HIV infection in adults.
• 4.32% ~ Viread is an oral formulation of a nucleotide analog reverse transcriptase inhibitor, dosed once a day as part of combination therapy to treat HIV infection in patients two years of age and older.
• Emtriva is an oral formulation of a nucleoside analog reverse transcriptase inhibitor, dosed once a day as part of combination therapy to treat HIV infection in adults.
• Tybost is a pharmacokinetic enhancer dosed once a day that boosts blood levels of certain HIV medicines.
• Vitekta is an oral formulation of an integrase inhibitor, dosed once a day as part of combination therapy to treat HIV infection in adults without known mutations associated with resistance to elvitegravir, the active ingredient of Vitekta.

Liver Diseases

I’ll start with some info about the seven major genotypes of HCV viruses, after describing “genotype”.

Every person has a gene for eye color. There’s an allele for brown eyes, an allele for green eyes, and an allele for blue eyes. Another example of an allele is the allele for lactose intolerance. A person’s genotype is their complete set of alleles. (I’m ignoring details like the existence of dominant and recessive alleles.)

Although virus reproduction is very different, they still have genes, alleles, and genotypes. Genotypes are grouped into classes, and HCV is currently divided into seven major genotypes, numbered 1 to 7 (according to Wikipedia, but most sources I’ve seen only mention 1 to 6). Genotype 4 is broken down into 4a, 4b etc. up to 4j, while genotype 5 has no sub-types (I’m not sure that’s up to date).

Approximate relative prevalence of genotypes in the U.S. –

Genotype 1 ~ 70%
Genotype 2 ~ 20%
Other genotypes ~ Wikipedia claims about 1% for each other major genotype, presumably leaving about 5% for all the minor genotypes.

Genotype 1 is also the most common genotype in South America and Europe.

Genotype 1 is subdivided into genotype 1a and genotype 1b, while genotype 2 is subdivided into genotypes 2a, 2b, 2c and 2d. I assume that when it’s stated that a product can be used for treating genotype 1, that includes the sub-variants. The 10-K for 2014 has “genotype 1” several times in connection with HCV, and no instance of “genotype 1a” or “genotype 1b”.

Sources: “Hepatitis C” (wikipedia.org), Genotype (wikipedia.org), “Hepatitis C” (hepatitiscentral.com – I’m not sure who they are), What are Genotypes? – Definition, Examples & Quiz (study.com).

For more simplified science, find “Sofosbuvir-aka-Sovaldi bio-chemistry”, below. I also write about “Compensated and decompensated cirrhosis of the liver”, below.

• 8.69% ~ Harvoni is an oral formulation of the NS5A inhibitor with a nucleotide analog polymerase inhibitor dosed once a day for the treatment of HCV genotype 1 infection in adults. … Harvoni is also indicated for certain patients … those with HCV/HIV-1 co-infection.
• 42.2% ~ Sovaldi is an oral formulation of a nucleotide analog polymerase inhibitor dosed once a day for the treatment of HCV as a component of a combination antiviral treatment regimen. … Sovaldi’s efficacy has been established in patients with HCV genotypes 1, 2, 3 or 4 infection (in United States and Europe) and genotypes 5 and 6 infection (in Europe), including … those with HCV/HIV-1 co-infection.
• (4.32%, listed under HIV) Viread is an oral formulation of a nucleotide analog reverse transcriptase inhibitor, dosed once a day for the treatment of chronic HBV in adults with compensated and decompensated liver disease. … Viread is also approved for the treatment of HIV infection.
• Hepsera® (adefovir dipivoxil) is an oral formulation of a nucleotide analog polymerase inhibitor, dosed once a day to treat chronic HBV in patients 12 years of age and older.


• Zydelig is a first-in-class PI3K delta inhibitor, in combination with rituximab, for the treatment of certain blood cancers.


• 2.43% ~ Letairis (ambrisentan) is an oral formulation of an endothelin receptor antagonist (ERA) indicated for the treatment of pulmonary arterial hypertension (PAH) (World Health Organization (WHO) Group 1) in patients with WHO Class II or III symptoms to improve exercise capacity and delay clinical worsening.
• 2.08% ~ Ranexa® (ranolazine) is an extended-release tablet for the treatment of chronic angina.
• Lexiscan®/Rapiscan® (regadenoson) injection is indicated for use as a pharmacologic stress agent in radionuclide myocardial perfusion imaging (MPI), a test that detects and characterizes coronary artery disease, in patients unable to undergo adequate exercise stress.


• Cayston® (aztreonam for inhalation solution) is an inhaled antibiotic for the treatment of respiratory systems in cystic fibrosis (CF) patients seven years of age and older with Pseudomonas aeruginosa (P. aeruginosa).
• Tamiflu® (oseltamivir phosphate) is an oral antiviral available in capsule form for the treatment and prevention of influenza A and B. Tamiflu is approved for the treatment of influenza in children and adults in more than 60 countries, including the United States, Japan and the European Union.


• 1.59% ~ AmBisome® (amphotericin B liposome for injection) is a proprietary liposomal formulation of amphotericin B, an antifungal agent to treat serious invasive fungal infections caused by various fungal species in adults.
• Macugen® (pegaptanib sodium injection) is an intravitreal injection of an anti-angiogenic oligonucleotide for the treatment of neovascular agerelated macular degeneration.


Gilead pipeline

The data is from counting blue bars on Gilead’s pipeline page. I’m not sure what a blue bar means, e.g. a blue bar completely across Phase 2 suggests the phase is complete, but all the blue bars go all the way across. I’ve emailed Investor Relations and not seen a reply. (I failed to draw a definite conclusion by looking into GS-4774, which has blue bars up to Phase 2, and is the subject of “Safety and Efficacy of GS-4774 in Combination With Tenofovir Disoproxil Fumarate (TDF) for the Treatment of Subjects With Chronic Hepatitis B and Who Are Currently Not on Treatment” (clinicaltrials.gov).)

There’s a statement at the top of the ‘pipeline’ page –

    “Safety and efficacy of the following compounds have not been established.”

In some cases, Gilead won’t get 100% of any profit, for example –

    “Complera/Eviplera is a fixed-dose combination of our antiretroviral medications, Viread and Emtriva, and Janssen’s non-nucleoside reverse transcriptase inhibitor, Edurant (rilpivirine).”

Some of the revenue from that would go to Janssen Pharmaceuticals (and when other companies use a Gilead product in a combination, it’s good news, rather than competition).

The pipeline page omits anything pre-clinical.

On Gilead’s site, the Earnings page has the PDF “Fourth Quarter 2014 Earnings slides” which includes diagrams for the pipeline which I prefer to the diagrams on the pipeline page, because it’s clear which phase a candidate is in. The pipeline page should be more up to date, though. The Earnings page also has the Q4 results and guidance for 2015, and audio for the earnings call.

Approvals timeline

I’ve reduced Gilead’s page showing year, picture and name, to number of approvals in this chart –

Gilead approvals numbers

The numbers add up to 22. The trendline I added should not be taken too seriously, but the four approvals in 2014 are probably above any reasonable trend, and a fall looks fairly likely. The R-squared of 0.416 means the trend line only explains 41.6% of the variation. The number of approvals in a year says nothing about the commercial potential of each of them.

Recent Phase 3 results for TAF (for HIV)

See “Gilead Announces Phase 3 Results for Investigational Once-Daily Single Tablet HIV Regimen Containing Tenofovir Alafenamide (TAF)” (investors.gilead.com).

The TAF regimen being tested was found to be “Non-Inferior” for treating HIV, with less side-effect damage to the liver and bones. The reason why TAF is needed is that HIV patients are living longer than previously, increasing the need for treatments which cause less damage. The trial subjects were adults with HIV-1 infection who had not previously received treatment.

Patent expiration timeline

Shareholders will know that Gilead have a good patent expiration timeline, with the big sellers Sovaldi and Harvoni not due to expire until 2029 and 2030. The expiry of Atripla and Truvada in 2021 is not so far off but is not imminent either. There’s a full list on page 17 of the 10-K for 2014 PDF. My table below shows the 2014 sales. It misses out the products in the two ‘other’ categories (in the product sales breakdown), but they only accounted for 1.04% of product sales. I compiled the table by combining the disclosures for sales per product, with the patent expiry table. I’ve shown a simplified (or kludged) version, because it only gives the date of U.S. expiry, along with global sales.

    “For our product that are single tablet regimens (e.g., Truvada, Atripla, Complera/Eviplera and Stribild), the estimated patent expiration dates provided correspond to the latest expiring compound patent for one of the active ingredients in the single tablet regimen.” (10-K for 2014)

The Harvoni combination gets it’s expiry dates based on the latest expiries of its two components. The combination only has patent applications and pending patents (there’s more on that later).

Gilead US patent expiry 2015 spread 3

The next chart tries to show the benefit of the U.S. expiry years, compared to the assumption of an equal amount of U.S. sales expiring every year (expiring with the patents), from 2015 to 2030.

The charts are only meant to give a very rough view, because various assumptions and fudges were needed due to the lack of detailed data. I assumed 2014 sales would repeat until patent expiry, followed by zero sales. I split the ‘rest of the world’ between U.S. and E.U. I did not adjust for Harvoni’s launch date, and because of that the timeline should be better than in the chart.

Gilead US patent expiry 2015

What counts in the chart is that the brown line is above the straight blue line, which means that annual sales are greater than they would be if the effect of expiry was spread evenly throughout the period.

The benefit is not so big for the E.U., but E.U. product sales were less than a third of the U.S. sales in 2014.

Gilead EU patent expiry 2015

One thing that seemed certain enough was the strength of the IP, because an expiration date tends to imply that a patent protects a product until expiry.

Litigation regarding Sofosbuvir

While the risk from the patent disputes may be hard for some people to judge (including myself), it should not be forgotten that nearly half of Gilead’s revenue in 2014 was not from hepatitis C (the disputed area), Gilead have a strong pipeline, and the valuation is relatively low.

Details of Gilead’s litigation start on page 18 of the 10-K PDF.

Sometimes, the U.S. Patent and Trademark Office (USPTO) notices that the claims of a pending patent clash or “interfere” with a patent that’s already been granted. They told Gilead about interference from pending patents for a class of compounds which includes metabolites of sofosbuvir, the drug in Gilead’s Sovaldi and one of two ingredients in Harvoni. (Metabolites are the result of the body’s metabolism turning one compound into other compounds. Technically, sofosbuvir (Wikipedia) is a “protide prodrug”, which is metabolized to an active antiviral.) The pending patents for the class of compounds belong to Idenix Pharmaceuticals, Inc.

In cases of interference, it was necessary to establish who was first to invent (under the law at that time). In March 2013, the USPTO Patent Trial and Appeal Board decided in favor of Gilead. The reason was that Idenix had not given instructions on how to make the disputed compounds. After that, the USPTO board decided Pharmasset (which Gilead acquired) were the first to invent sofosbuvir, because Idenix couldn’t prove they thought of it first, or identified the structure of the compounds or any use for them, or tested them, in the relevant time period. Idenix has appealed to the U.S. District Court for the District of Delaware. That’s only the “First Idenix Interference”. In the “Second Idenix Interference”, Gilead have won the first phase.

(The law has changed, as most of the Leahy-Smith America Invents Act (Wikipedia) became effective on September 16, 2012 and March 16, 2013. America’s principle of “first to invent” was out of step with the rest of the world, which operates on “first to file”. It’s easy to see which filing date was earlier, but the content still needs to be examined, for example to see if it described how to make a compound. The law does not affect previous patents, and it’s the pre-Leahy-Smith law that applies to Gilead’s patent disputes over sofosbuvir.)

The dispute has spread to other Idenix patents, such as ‘191 and ‘572, although patent numbers could be different because they are filed overseas. The dispute has gone on a world tour, with Idenix losing in Norway and the U.K., and withdrawing in China. A trial in Canada started in January 2015. A decision from a court in Düsseldorf, Germany, was expected in mid-March 2015. A trial will start in Sydney, Australia, in September 2015.

From the 10-K,

    “Idenix was acquired by Merck in August 2014. While the acquisition does not change our view of the lack of merit in the claims made by Idenix, Merck has greater resources than Idenix and may therefore choose to fund the litigation at higher levels than Idenix.”

Litigation with Merck

From the 10-K for 2014 –

    “In August 2013, Merck contacted us requesting that we pay royalties on the sales of sofosbuvir and obtain a license to U.S. Patent Nos. 7,105,499 and 8,481,712, which it co-owns with Isis Pharmaceuticals, Inc. We believe that Merck’s patents are invalid and are not infringed by” etc.

For more about Merck, find “Merck’s HCV pipeline” and the link “Merck’s hep C drug no longer a ‘breakthrough’”, below.

See also “Gilead Sciences: Clear The Dockets And Settle With Merck Already” by Small Pharma Analyst, Oct. 21, 2014 (seekingalpha.com). There are some good points in the comments about why Merck’s case is probably weak. It’s still true that judges don’t always decide correctly or as expected. Chemist357 pointed out that Merck’s provisional patents expired worthless. For a provisional patent to stake an invention date, the patent application had to be filed within 12 to 13 months.

Litigation with AbbVie, Inc.

USPTO (the U.S. Patent and Trademark Office) is likely to refuse a patent for a combination of two drugs which attack different vulnerabilities of the same pathogen, on the grounds that it’s an obvious thing to try. It’s not too surprising that Gilead has no patent for the combination of sofosbuvir and ledipasvir in Harvoni. More surprising is the granting of five patents for the combined use of the same two drugs to Abbvie. Instead of claiming their scientists had discovered the combination, Abbvie claimed it was the result of a virtual model. That seems to have been enough to convince USPTO that AbbVie’s combinations did not fail the test of obviousness.

You can find statements by Gilead starting at the bottom of page 20 of the 10-K PDF.

      “We own published and pending patent applications directed to the use of combinations for the treatment of HCV, and, specifically, to the combination of ledipasvir and sofosbuvir. Certain of our applications were filed before the AbbVie Patents. For this reason and others, we believe the AbbVie Patents are invalid.

Accordingly, in December 2013, we filed a lawsuit in the U.S. District Court for the District of Delaware seeking declaratory judgment that the AbbVie Patents are invalid and unenforceable, as well as other relief. We believe that Abbott Laboratories, Inc. and AbbVie conspired to eliminate competition in the HCV market by falsely representing to the USPTO that they, and not Gilead, invented methods of treating HCV using a combination of ledipasvir/sofosbuvir. In February and March 2014, AbbVie responded to our lawsuit by filing two lawsuits” etc.

Obviously, “If a court determines that the AbbVie Patents are valid and that we have infringed those claims, we may be required to obtain a license from and pay royalties to AbbVie to commercialize sofosbuvir combination products.”.

I’ve included a few links –

AbbVie (ABBV) Uses Patents To Ambush Gilead Sciences, Inc. (GILD)” by Mark Terry, Breaking News Staff, 11/13/2014 (biospace.com)

Gilead Sciences Gets Ambushed By The Patent Troll, AbbVie” by Small Pharma Analyst, Nov. 12, 2014 (seekingalpha.com). With 325 comments, most of the arguments are likely to have been made already.

The Seeking Alpha piece prompted – ‘“Seeking Alpha” labels Abbvie a patent troll.‘ by Lawrence B. Ebert, November 12, 2014 (blogspot.co.uk), although it was the author Small Pharma Analyst and not Seeking Alpha who used the ‘troll’ label.

The Seeking Alpha article is long and highly informative. The biospace and Seeking Alpha articles both use the word “ambush”. Both authors expect the case to drag out over years. Small Pharma Analyst supports the “troll” label by explaining the obstacles to Abbvie commercializing a copy of Harvoni, which only leaves the extraction of cash from Gilead as the way to exploit the relevant patent claims. Although firms that specialize in “patent trolling” have faced some headwinds in recent years, the ‘trolling’ is not illegal. (For the basics of patent claims, see “How do I read a patent? – the Claims” (bpmlegal.com) and find the “motor vehicle” example.)

Gilead’s accusation of conspiring to eliminate competition is more colorful than you normally see in a 10-K. I can understand them being outraged, but fear of massive loss would also be consistent with the tone of the statement. Gregg H. Alton, an Executive VP, is a member of “the U.S. Government’s Industry Trade Advisory Committee on Intellectual Property Rights” (under Senior leadership), and the company has been through enough litigation that inexperience is not a likely factor. See Small Pharma’s article for more fairly extreme accusations in Gilead’s lawsuits.

About a lawsuit against AbbVie – “Gilead in 2013: AbbVie sought to eliminate competition and dominate market for HCV drugs” by James Love, July 16, 2014 (keionline.org).

You might not expect gas pedals to have much to do with drug combinations, but see “Is Chunky Monkey an Obvious Combination?” by Peter Pitts, 5.23.07 (spectator.org).

About obvious combinations and prior art, in order of increasing unreadability – the U.K. (genericsweb.com), the European Patent Office (epo.org), and USPTO (uspto.gov).

Litigation with generic manufacturers

This mostly concerns Teva Pharmaceuticals, over Tenofovir Disoproxil Fumarate, Emtricitabine and Fixed-dose Combination of Emtricitabine, Tenofovir Disoproxil Fumarate and Efavirenz, and you can find the details on page 21 of the 10-K PDF.

It’s an obvious tactic for a generics manufacturer to try to break patents. It’s less expensive than developing new drugs, but when patents are successfuly broken, the generics manufacturer has no monopoly on the benefit.

Doctors of the World

Charity challenges Gilead’s European patent on hepatitis C therapy Sovaldi” (Ref: Bloomberg, The Guardian, CNBC, Doctors of the World – Médecins du Monde) by Joe Barber, February 10th, 2015 (firstwordpharma.com). Médecins du Monde claim that Sovaldi depends too much on a breakthrough at Cardiff University, and have filed a patent challenge with the European Patent Office. Médecins du Monde (Wikipedia) are a non-profit that provide medical care and campaign for equal access to healthcare.

Also in the piece, in January, India refused a patent for Sovaldi, implying that the inventive step was too small. I suspect their conclusion, because even if Gilead only tweaked a molecule as alleged, the effect of tweaking a molecule is not necessarily obvious. The tweak might not be easy to make, even if the chemical diagram does not change much. Both those points seem likely to be magnified when it’s only the metabolites that are active. Roche were an early leader in HCV, but their products were never good enough, which supports the view that success was not easy. The same applies to Bristol-Myers Squibb, who acquired key IP (see “Hepatitis C drug set to give Cardiff University financial boost” 12 January 2012 (bbc.co.uk)). If there was an obvious and easy way to build on the university research, it begs the question, why did the researchers at the university or at Bristol-Myers Squibb not make that last inventive step.

Awards for patent infringement

Awards in patent disputes are meant to compensate for lost profits and the extra costs incurred. That naturally includes backdated royalties. I’ve read that big awards for patent infringement are scaled back on appeal more often than not, but I can’t find a link which confirms that.

I googled “record patent awards” and the biggest I could see was “Jury Awards $1.67B to Drugmaker in Record-Breaking Patent Verdict” by Martha Neil, Jun 29, 2009 (abajournal.com).

Following that up – “Abbott Wins Reversal of J&J’s $1.67 Billion Patent Victory” by Susan Decker, February 23, 2011 (bloomberg.com).

The 2011 piece gives Abbott’s worldwide sales of Humira (the relevant product) at around $6.6 billion. If I assume the sales were the same in 2009, the ratio of award / sales = 0.2530303 or 25%. Although that’s for a record-breaking award (for patent infringement), the size of the annual sales would be a large factor. The ratio of award / sales is probably not record-breaking, but IMO it’s likely to be above average. 25% of sales is big when sales are big, but not likely to be a company-killer. Because pharma costs are mostly up-front, with high gross margins, an award like that does not look as bad as failing phase 3, not getting approval, or having very low sales due to a superior competing product, all normal risks for a pharma company.

I did not find another case where damages and the infringer’s sales were both reported, and the studies I found showed the academics had no interest in the relation between the two quantities. A single case is not much to go on but better than nothing.

The amount in a settlement depends on how the case develops, perceptions of the strength of a case and the likely size of an award, attitude, etc.

Pfizer Reaches $2.15 Billion Protonix Accord With Teva” by Sophia Pearson, Susan Decker and David Voreacos, June 12, 2013 (bloomberg.com)

Assuming Teva and Sun’s sales equaled Pfizer’s lost Protonix sales, their annual sales were –





      = 1094

Settlement / Annual sales
= 2150 / 1094
= 1.9653
= 197%

That’s much higher than the award / sales of 25% for the Abbott vs J&J case.

Assuming the infringing sales only occured in 2008, 2009 and 2010 (the patent expired in January 2011) –



      x 3 years


      = 3,282

Settlement / Total sales (over the three years)
= 2150 / 3,282
= 0.6550 or 65.5%

It was a clear case of jumping in before expiry, and Pfizer’s lost sales really were evident in a lower sales figure. Generics manufacturer’s have smaller gross margins, and the settlement would have hurt. Abbott vs J&J seems more relevant, but it’s just one case.

This lists various IP deals, awards and settlements – “Patent/copyright infringement lawsuits/licensing awards“.

These academics claim to have figured it out – “Explaining the “unpredictable”: An empirical analysis of U.S. patent infringement awards” (PDF) by Michael J. Mazzeo, Jonathan Hillel, Samantha Zyontz, Accepted 2 March 2013 (kellogg.northwestern.edu). I’m not convinced that forward citations are a good proxy for the economic value of patents. I’d guess that applying the methods to cases could produce an endless stream of ‘cookie-cutter’ articles.

Sofosbuvir aka Sovaldi bio-chemistry

Some knowledge of the bio-chemistry should help when assessing competitors’ pipelines, because there are no sales figures to go on. This is meant for people who don’t know much of the science, and while I’ve made it simple, it won’t be as reliable as if I’d regurgitated the technicalities.

The hepatitis C virus (HCV) hijacks a host cell’s machinery to make copies of itself. The virus has a strand of RNA that codes for making proteins, and those strands of RNA need to be reproduced. Each strand of RNA is actually a chain of nucleotides, and a new strand of virus RNA is made by adding one nucleotide at a time to the end of a growing chain.

One way to stop or reduce the virus’s reproduction is to give it some fake nucleotides. That’s a tricky proposition, because the fakes have to be close enough to the real thing to be added to the chain, but they can’t be exactly the same because the whole point is that a chain which includes a fake does not work like a normal strand of virus RNA. The fakes also have to be very effective against virus reproduction compared to the harm they do to the patient.

In the body, Sofosbuvir is turned into metabolites which are “nucleotide analogs”, which means fake nucleotides.

RNA can be understood as a kind of template for building proteins, with the template being read one nucleotide at a time. The nucleotide analogs (the fake building blocks) are designed so that when one of them is read, it’s interpreted as a kind of end-marker, with the effect of saying “stop what you’re doing, we’re finished”. Getting technical, the end marker is called a “stop codon”, and when it causes the chain-building to stop, it’s called “RNA chain termination”.

The chain-building involves a thing called a polymerase. A polymerase is an enzyme that builds a polymer, “polymer” is the word for any kind of molecular chain, and DNA and RNA are both polymers.

NS5B is the Hepatitis C virus’s RNA polymerase, which it uses to replicate its RNA.

If you see Sofosbuvir described as a “nucleotide analogue inhibitor of HCV NS5 B polymerase”, you should now have some idea of what that actually means –

nucleotide analogue – fake building block with a sneaky “stop” sign.
inhibitor of … polymerase – stops the polymerase from finishing a long molecule (by putting an early “Stop!” sign in the template).
HCV – the hepatitis C virus
NS5B – the virus’s RNA polymerase, which it uses to replicate its RNA.

When I read “nuc”, I assume it’s short for “nucleotide analogue” and that it probably inhibits something vital for virus reproduction. “nuc”s are generally good for most genotypes, because all versions of a virus have to make use of the same four or five kinds of “building-block” nucleotides. They are good to have in drug combinations for HCV because they work across many genotypes and act differenctly to other kinds of antiviral. The more efficient a “nuc” is, the less need there is for combining it with drugs that cause severe side-effects. It wasn’t easy to get a good “nuc”, and getting a “nuc” as good as sofosbuvir or better, which is also different enough to be patented, will not be easy.

It’s harder for a virus to evolve resistance to a combination of effective anti-viral agents, because a mutation that gives resistance to one of them should not allow the virus to reproduce and spread the resistance, due to the effect of the other antivirals.

One more term. You might see “Uridine” in a description of Sofosbuvir, as in

“Uridine nucleotide analogue inhibitor of HCV NS5 B polymerase”

There are five kinds of nucleotides. Three of them occur in both DNA and RNA, but the nucleotides built around thymine are only in DNA, and the nucleotides built around uracil are only in RNA. Uridine is a kind of nucleotide analog built around uracil (well, not quite, because it’s a nucleoside, but I can’t explain everything). You don’t need to make every building block a fake, you just need to have at least one fake in a sequence often enough (and not at the end), and faking the uracil nucleotides is good enough.

I’ve missed a lot out, (ribosomes, positive sense RNA, messenger RNA, etc.) which you can tell if you look up the links.

Wikipedia: Nucleoside analogue, Nucleotide, RNA polymerase, Hepatitis C virus, Translation (biology).

Other sources: Nucleoside and Nucleotide NS5B Polymerase Inhibitors (medscape.com), Nucleoside/Nucleotide Analogues (emedicinehealth.com, about hepatitis B).

Protease inhibitors

HIV and hepatitis C viruses make a number of different proteins by making them all in one long molecule, and then slicing the molecule into the parts they need. The slicing up is done by their protease enzymes. A protease inhibitor is an antiviral molecule which attaches itself to the protease enzyme and stops it from working. See “Protease inhibitors” (aidsmap.com).

Gilead have two HIV products which work in combination with protease inhibitors, and have a combination for HCV in Phase 2 which includes a protease inhibitor. (From the 10-K, slightly ediited – Fixed-dose combination of GS-9857, sofosbuvir and GS-5816 – GS-9857 is a pan-genotypic NS3 protease inhibitor being evaluated in combination with sofosbuvir and GS-5816 for the treatment of HCV.)


    “If successfully developed and approved by regulatory authorities, this treatment would represent the first protease inhibitor-based STR and thereby continue Janssen’s commitment to providing its HIV products in more simplified dosing presentations.” (10-K for 2014)

(STR is probably “single tablet regimen”.)

Merck’s HCV pipeline

Of the three Hepatitis C candidates listed on Merck’s pipeline page, one is a combination in phase 3, and the other two are combinations in phase 2.

The phase 3 combo is of grazoprevir and elbasvir, each of which is oral and once-daily, and for treating chronic hepatitis C. The combo is an Investigational New Drug (IND), which only means the company has permission from the FDA to ship the drug across state lines before a marketing application has been approved. The 10-K has –

    “MK-5172A, a once daily, fixed-dose, combination, chronic HCV treatment regimen consisting of MK-5172, grazoprevir, an investigational HCV NS3/4A protease inhibitor, and MK-8742, elbasvir, an investigational HCV NS5A replication complex inhibitor, began Phase 3 clinical trials in June 2014. MK-5172A is being investigated in a broad clinical program that includes studies in patients with multiple HCV genotypes who are treatment-naïve, treatment failures, or who fit into other important HCV subpopulations such as patients with cirrhosis and those co-infected with HIV.”

Elbasvir is described as a “HCV NS5A replication complex inhibitor”, which has some similarity to Gilead’s NS5A inhibitor ledipasvir, one of the drugs in Harvoni (the other is sofosbuvir, a NS5B polymerase inhibitor). Harvoni is on sale, but Gilead also have GS-5816, a pangenotypic NS5A inhibitor, and a combination with sofosbuvir is currently in Phase 3 clinical trials. AbbVie and Achillion each have a NS5A inhibitor In Phase 2 (AbbVie’s is ABT-530, and Achillion’s is ACH-3102).

The phase 2 entries on the pipeline page don’t have much detail. One has both grazoprevir and elbasvir, as for the phase 3 combo, and the other has grazoprevir without elbasvir. They both have MK-3682, which I describe later in this section.

From the news item “Interim Data from Proof-of-Concept Study of Merck’s Investigational Hepatitis C Treatment Grazoprevir/Elbasvir in Combination with a Nucleotide Inhibitor (C-SWIFT study) Presented at The Liver Meeting®” Sunday, November 9, 2014 (mercknewsroom.com),

    “To date, no discontinuations due to an adverse event and no drug-related serious adverse events have been reported. Most adverse events were mild or moderate in intensity, with no apparent dose effect.”

I don’t know just how serious the adverse events were. It remains to be seen just how bad they’ll be in phase 3, and the effect on demand, pricing and sales if the combo gets through the remaining stages.

(This section is about Merck’s HCV pipeline, but I’ll mention that the pipeline page has a HIV candidate in phase 3 – “MK-1439 is an investigational orally available HIV non-nucleoside reverse transcriptase inhibitor (NNRTI) being evaluated for the treatment of HIV infection.”, with a link for the clinical trials. The HIV candidate is “investigational”.)

There are two relevant tables in “Is Merck Ready To Soar Or Flop? The Challenging Question Of Predicting Pipeline Potential” by Pharma Doc, Mar. 17, 2015 (seekingalpha.com). The tables compare Gilead’s Harvoni, Abbvie’s Viekira Pak (both on sale), and Merck’s MK-5172A aka Grazprevir/Elbasvir (in Phase 3). The data used is from phase 2 and phase 3 clinical trials. Taking into account Abbvie’s higher pill count and the side effects, Merck’s candidate seems to be slightly inferior to Harvoni, but better than Abbvie’s Viekira Pak. “GT1” means “genotype 1”, and the author seems to regard MK-5172A as being only good for that genotype, probably for a good reason, although the quote above from Merck’s 10-K included “patients with multiple HCV genotypes”.

The author is also hopeful about an HCV combination made possible by Merck’s acquisition of Idenix. It looks like the combo is MK-3682/MK-8742 (elbasvir)/MK-5172 (grazoprevir), the phase 2 candidate with the mild or moderate adverse events. It seems to be aimed across genotypes, and would compete with Gilead’s Sovaldi. The 10-K says very little except “The Company expects to begin Phase 3 studies in 2015.”, and does not give the combo a name. The component MK-3682 was acquired from Idenix, and it gets –

    “MK-3682 is a nucleotide prodrug in Phase 2 clinical development being evaluated for potential inclusion in the development of all oral, pangenotypic fixed-dose combination regimens.” (Merck’s 10-K)

“prodrug” means it’s the metabolites which are active against viruses (as for Gilead’s sofosbuvir, aka Sovaldi).

“nucleotide” is also in common with Gilead’s sofosbuvir, which is described as a “nucleotide analog polymerase inhibitor” in the 10-K (nucleotides are described in “Sofosbuvir aka Sovaldi bio-chemistry”, above).

In other words, Merck’s MK-3682 looks like a “nuc”, and because of the adverse events it’s probably not as good as Gilead’s “nuc” (Sofosbuvir), even though the “adverse events were mild or moderate in intensity”.

Achillion’s HCV pipeline

The pipeline shows four compounds, two in phase 2, one in phase 1, and a compound between discovery and preclinical. Clicking the names gets more detailed information.

The first compound, in phase 2, is called ACH-3102. It’s an HCV NS5A Inhibitor, which Achillion claim is “second generation”. They also say it’s been “fast tracked” by the FDA, but I wouldn’t be surprised if technically it’s been given a Breakthrough Therapy Designation. There’s a pilot Phase 2 for the use of ACH-3102 in combination with Gilead’s sofosbuvir, and that might be all the compound’s phase 2 activity. Gilead, Merck and AbbVie have NS5A inhibitors in trials, find “Elbasvir is described as a” above. Gilead’s Harvoni includes a NS5A inhibitor and is selling well.

Achillion’s phase 2 candidate pairs their HCV NS5A Inhibitor with Gilead’s HCV NS5B Inhibitor (sofosbuvir). I’m sure they would rather use their own NS5B polymerase inhibitor if they could. That’s the second compound on the pipeline page, in phase 1, a pro-drug uridine nucleotide analog NS5B polymerase inhibitor (after rearranging the words), the same description as Gilead’s Sovaldi/Sofosbuvir (so it’s a “nuc”). It does not seem to be as good as sofosbuvir, as it needs to be taken with ribavirin or pegylated interferon or both, which have side effects. There are some other criticisms in Achillion: The Dark Side by Kanak Kanti De, Feb. 26, 2015 (seekingalpha.com).

Nasdaq give Achillion a market cap around $1.24 billion. Revenue so far has been zero. Liquid assets from cash to receivables are nearly $160 million.

UPDATE: Achillion Pharmaceuticals (ACHN) Will Be Left Behind, Barclays Starts at Underweight” March 3, 2015 (streetinsider.com) – the short piece looks a few years ahead, and puts Gilead and Merck ahead of Abbvie, but the opinions are not explained.

For more research into Achillion, you could start with Seeking Alpha. One recent news item is the resignation of the Chief Regulatory Officer.

My own research into Achillion has not gone much farther than what you see here.

Selling a combination which is mostly sofosbuvir is great news for Gilead, but it might not be such good news for Achillion. I haven’t seen anything from them that looks like it would beat or equal sofosbuvir in a combination, which seems to make them less of a threat to Gilead than almost any company with positive cash flow, ambition in the area, and some relevance to the market. Cash-burners can also find it harder to raise cash when the market they hope to address is declining, although in this case the peak has not yet been reached, and Achillion have been able to raise capital. (Find “prevalence peaked in the 1990s”, below.) Sometimes genius is surpassed by even greater genius, and that’s probably what Achillion would need to be a threat to Gilead. I’m not saying Achillion are doomed, just that they are not likely to be a serious threat, based on the little information I’ve gathered.

Achillion’s NS5A inhibitor in phase 2 would be more valuable to Gilead than to anyone else, because owning it would mean owning the whole combination. If the combination of the inhibitor and sofosbuvir has not been spat out by AbbVie’s magic model, owning the combination would reduce Gilead’s vulnerability if they lose the patent dispute. But, the combination might not be as good as the candidates in Gilead’s liver disease pipeline, and Gilead might not want to show interest in an acquisition while Achillion’s stock is high on acquisition hopes.

If Merck acquires Achillion, it would be with the intention of using Achillion’s HCV NS5A Inhibitor with their own HCV NS5B Inhibitor (because they don’t need another NS5B “nuc” which is not as good as Gilead’s). Trials for the combination would have to start from scratch. While the combination is likely to be inferior to the NS5A Inhibitor/Sofosbuvir combination which Achillion are putting through trials, it might still improve Merck’s position in HCV relative to Gilead, but the necessary clinical trials would take years, and the market is due to peak. Merck could face complications if they apply for a “breakthrough” designation with the FDA, because the combination would probably be inferior to Achillion’s combination (with Gilead’s Sofosbuvir), and killing that combination to make their own rank higher would probably not impress the FDA. Against that last point, Achillion were hoping to replace Sofosbuvir with their own version as much as they could, and the problem seems to be with the quality of their version, not the attitude of the FDA.

When the FDA rescinded its Breakthrough Therapy designation for Merck’s HCV combination of grazoprevir and elbasvir, Achillion’s stock fell, apparently because Achillion’s breakthrough designation might be at risk, and future breakthrough designations are less likely, as the FDA’s action shows they believe the number and standard of HCV treatments warrants raising the bar. See “Why Achillion Pharmaceuticals, Inc. Stock Is Crashing Today” by George Budwell, February 4, 2015 (fool.com).

Abbvie’s HCV pipeline

Abbvie’s HCV pipeline has a combination for HCV genotype 1 which does not need Interferon, in “PHASE III/SUBMITTED”, and a combo in phase 2. There’s no information about phase 1.

From “AbbVie’s (ABBV) CEO Richard Gonzalez on Q4 2014 Results – Earnings Call Transcript” Jan. 30, 2015 (www.seekingalpha.com) –

    “Clearly another important driver of performance in 2015 will be our interferon-free HCV therapy Viteron [ph] which is now been approved in the US, EU and a number of other countries around the world. We are pleased with Viekira product label and updated AASLD treatment guidelines and we believe both reflect the strength of the product’s clinical profile across genotype-1 patient population.”

I can’t find anything else about “Viteron”, and I’m wondering if it’s a transcription error. I can’t see it on “2014 FDA Approved Treatments For Hepatitis C” or “New Hepatitis C Drugs Coming in 2015” by Nicole Cutler L.Ac., January 12, 201 (hepatitiscentral.com).

All I could find in AbbVie’s 10-K about their HCV pipeline was –

    “AbbVie is also currently conducting Phase 2 studies of its next-generation HCV program which includes ABT-493, a potent protease inhibitor, and ABT-530, AbbVie’s new NS5A inhibitor.”

Gilead, Merck and AbbVie have NS5A inhibitors in trials, find “Elbasvir is described as a” above. Gilead’s Harvoni includes a NS5A inhibitor and is selling well.

I have not found much detail about Abbvie’s HCV pipeline. In addition to their normal development pipeline, Abbvie’s virtual model and legal action can be seen as an another way to get income from intellectual property in addition to acquisitions or developing the pipeline.

Further research into competition in the pipeline

One line of research is to go to www.clinicaltrials.gov and search for HCV. Not every result will be relevant. The site was not designed for investors and I haven’t seen any info linking trials to companies.

Recent financial results

In the table below, I’ve noticed that I have not been consistent about making expenses negative and red. I needed most of them to be positive, for the appearance of the chart (the 3D chart after the table).

Gilead 3 years earnings to 2014 spread

Gilead 3 years earnings 3D

Gilead margins

Gilead cash flow 2012 - 2014 spread

Gilead cash flow 2012 - 2014

Gilead balance sheet spread

Gilead balance sheet

About the “Long-term marketable securities”, I believe they are relatively realizable. On page 93 of the 10-K PDF for 2014, they are classed as “available-for-sale securities”, of which only $18 million have a contractual maturity over 5 years (compared to $1,598 million of Long-term marketable securities). None of the assets recorded at fair value are “Level 3”, the hardest of the three levels to assess (for 2013 or 2014).

To see figures for the fantastic growth from 2005, and excellent returns metrics, see Morningstar’s Ratio tab (morningstar.com/ratios).


Sometimes companies are too enthusiastic about capitalizing costs to make them look like investment instead of expenses. Nothing in the investment cash flow suggested that. I found “We had unamortized capitalized software costs on our Consolidated Balance Sheets of $80 million as of December 31, 2014 and $84 million as of December 31, 2013.”, and “We capitalized $20 million related to the milestone incurred in connection with the FDA approval of Stribild and $12 million related to the milestone we incurred in connection with the European Commission approval. Both milestones are being amortized over the useful patent life of elvitegravir, which is approximately 10 years, expiring in 2023.”. The “accumulated depreciation and amortization” of $620 million includes “$2 for 2014 and 2013 relating to capitalized leased equipment”, i.e. $2 million, and while the value of capitalized leased equipment will be a lot bigger than that I’d guess it’s still small. Because life is short and the items are small compared to the $2,854 million R&D expense, I did not worry about whether or not the capitalizations were proper.

Full Year 2015 Guidance

The guidance is in the earnings call, the earnings release and the “2015 Guidance” PDF on Gilead’s Earnings page. In the following table, the first three columns show the 2015 guidance, and they are likely to be the most reliable columns.

Guidance only gave Product sales, and not Royalty, contract and other revenues. Instead of adjusting guidance to include royalties etc., I adjusted the 2014 figures where necessary to exclude the royalties etc., to give a reasonably fair comparison with the guidance, although I’m not asking anyone to trust the comparison a lot. A full explanation would have taken too much time and space. If you need to know what I did, you can find the formulas by finding “The spreadsheet formulas” above, for a link. I calculated the 2014 non-GAAP gross margin backwards from the non-GAAP EPS, and if you find a better source, that might not be necessary.

It was reasonable to put the highest R&D expenses under the ‘Worst case’ columns, but I don’t mean to imply that high R&D expense is bad. Similarly, SG&A expense is necessary to build the business, and a higher expense is only likely to be bad if it’s the result of inflation or inefficiency.

Gilead guidance for 2015 spread

Gilead beat Q4 analyst estimates after Q3 fell short (according to Zacks on Yahoo). Apparently the outlook disappointed. Estimates were “crushed” back in Q1 according to Gilead Beats by a Billion” by: Ian Wyatt, 05/09/2014 (moneyshow.com), which shows that analysts can be wrong about Gilead.

2014 net product sales beat revised guidance. Non-GAAP R&D expenses were bigger than guided, due to two one-offs – buying a voucher for FDA priority review, and a collaboration with Ono Pharmaceutical, possibly buying the rights to Ono’s Once daily BTK inhibitor outside of Japan, China and ASEAN countries (for the treatment of B-cell malignancies and other diseases).

I thought Gilead’s 2015 guidance was probably conservative, and I’m not alone – find “Michael Yee and RBC Capital” below.

Compensated and decompensated cirrhosis of the liver

Anyone with a liver problem should refer to reputable sources and not rely on my writing (investors can do the same, if they have the time).

According to Wikipedia, 30% of cases of cirrhosis are caused by hepatitis B, and 27% by hepatitis C. Those are global figures and they could be lower for the U.S. and other developed countries. The second most common cause is alcohol consumption. Wikipedia gives bullet points to 16 causes.

Cirrhosis of the liver is permanent scarring, which results when the liver tries to repair damage. The damage means it doesn’t work as well.

Compensated cirrhosis is the first stage, with relatively light damage, and patients might not be aware of anything wrong at first. Symptoms include feeling tired, nausea, abdominal pain, loss of appetite, weight loss, and small red spots on the skin called spider angiomas.

Decompensated cirrhosis is the second stage, with serious liver damage. Symptoms include fluid buildup in the legs, feet and abdomen, itching, bruising and bleeding, and the skin yellowing (jaundice). For the non-squeamish, there’s a picture on Wikipedia.

For more symptoms and detail, see Wikipedia or “Cirrhosis” (umm.edu/health).

Pharmasset acquisition

The Pharmasset acquisition (for hepatitis C drugs) was criticized at the time due to the price and the lack of meaningful revenue. For one example of the criticism, find “Paying Too Much” in “Gilead to Buy Pharmasset for $11 Billion to Win in Hepatitis” by Margaret Tirrell and Ryan Flinn, November 21, 2011 (bloomberg.com). Gilead were already the leaders in HIV, and now lead in hepatitis C. One risk is that another big deal might not go as well, although the company is now bigger and could survive a setback better.

With Pharmasset, Gilead acquired Sofosbuvir which is now sold as Sovaldi. Harvoni contains Ledipasvir (which Gilead already had) and Sofosbuvir.

The hepatitis C cures

Sovaldi is generally useful against HCV across genotypes as part of a combination, while Harvoni targets genotype 1, the common genotype which infects 70% of HCV patients in the U.S..

Sovaldi is the commercial name for the drug sofosbuvir. It was approved in the U.S. in December 2013, and by the European Commission in January 2014 for genotypes 1 to 6. Gilead claimed high rates of cure and a shortened course of therapy (12 weeks), patients who can’t take Interferon had their first option for a completely oral treatment, and previously there was no effective regimen to stop HCV from recurring after a liver transplant, that could be taken while waiting for a transplant. See this News release about the E.C. approval. The claim that Sovaldi was good for genotypes 1 to 6 was qualified by –

    “The clinical data supporting the use of Sovaldi in patients with genotypes 5 and 6 is limited.”

but the 10-K for 2014 has –

    “Sovaldi’s efficacy has been established in patients with HCV genotypes 1, 2, 3 or 4 infection (in United States and Europe) and genotypes 5 and 6 infection (in Europe),”

The problem may be that genotypes 4, 5 and 6 are uncommon in Europe.

Harvoni combines ledipasvir with sofosbuvir (aka Sovaldi). It was approved in the U.S. in October 2014, and in the E.U. in November 2014. Harvoni is a single pill once a day, benefiting the “type 1” patients who needed to take interferon and ribavirin with Sovaldi, or use Viekira Pak from competitor AbbVie with a higher pill count. The pill count affects how regularly patients take the pills, and the regimen is obviously less effective if the pills are missed or taken at the wrong time.

From “Gilead Sciences’ (GILD) Management Presents at Cowen & Company 35th Annual Health Care Conference (Transcript)” Mar. 3, 2015 (www.seekingalpha.com),

    “Harvoni is recommended for genotype 1 patients and requires a dramatically lower pill count compared to Viekira Pak.”.

Sovaldi sold $10 billion worldwide in 2014, with 32,000 patients treated. 31,000 patients started treatment with Harvoni between launch and the end of 2014.

Market share in HIV and Hepatitis C

Biotech Head-to-Head: Gilead vs. Celgene” by Todd Campbell and Michael Douglass, February 26, 2015 (fool.com). An industry analyst (and enthusiastic shareholder) implies that around 80% of new HIV patients have a treatment which involves a drug from Gilead.

This site has too much page junk, IMO – “Gilead Sciences, Inc. Continues To Lead The Hepatitis C Market; Its HCV Drugs See 4.5% Growth” by Hannah Ishmael, Feb 28, 2015 (bidnessetc.com). The prices in the article look higher than the prices likely to apply in practice, find the link with “US pharmacy deals could cut costs”, below.

Why Gilead Sciences Doesn’t Seem Too Worried About AbbVie’s Hep-C Treatment” by Ben Levisohn, February 17, 2015 (blogs.barrons.com).

This is probably the most relevant link – “The Hepatitis C Scorecard: Gilead is Trouncing AbbVie, but at a Price” by Ed Silverman, Feb 12, 2015 (blogs.wsj.com). The ‘price’ is the discounts Gilead had to make, find “46% overall discount”, below. Also find “Info about prescriptions” below, about getting weekly figures for US prescriptions.

Hepatitis C (HCV) numbers

2% to 3% of the world’s population are estimated to be infected by hepatitis C, with a lower rate of infection in developed countries, see “Hepatitis C” by Deborah Holtzman (Centers for Disease Control and Prevention). Applying 2% to 3% to a world population of 7.2 billion gives 144 million to 216 million.

Many cases are undiagnosed, and when diagnosed, many cases are not treated unless or until there are serious effects, such as cirrhosis of the liver. About the delay in treating diagnosed cases –

    “in many countries patients are unlikely to use prescription drugs that are not reimbursed by their governments. In addition, negotiating prices with certain governmental authorities can delay commercialization by 12 months or more.” (10-K for 2014)

Infection is through sharing or reusing hypodermic needles, or unscreened blood transfusions or unscreened organ transplants. In developed countries, screening is much more effective than in the past. It’s harder to reduce infection by intravenous drug users who share needles.

The WHO has reported the prevalence of transfusion-transmissible infections (TTI) in high, middle and low income countries. For HCV prevalence in blood donations, the figures are –

      0.02% for high-income countries


      0.37% for middle-income countries


    1.07% for low-income countries

but with quite wide ranges in each case.

The figures are from “Blood safety and availability” Fact sheet N°279, Updated June 2014 (who.int).

Myanmar is an exception I did not expect, see “Myanmar National Blood Center: Receiving a Prestigious International Award” June 1, 2014 (jica.go.jp).

The piece in the next link claims that prevalence peaked in the United States in the 1990s and will be down to a third of the peak level by 2030. Serious liver disease peaks later than prevalence, and the delay should mean that the incidence of disease can be predicted more easily. “Revolutionizing Treatment Outcomes in Hepatitis C: Managed Care Implications and Considerations—The New and Evolving Standards of Care” by Gary M. Owens, MD, March 24, 2015 (ajmc.com)

This is a bit old, but it looks quite far ahead – “U.S. Hepatitis C-Related Health Care Costs to Peak at $9.1B in 2024” January 24, 2013 (hepmag.com).

The paper – “Chronic Hepatitis C Virus (HCV) Disease Burden and Cost in the United States” by Razavi H, Elkhoury AC, Elbasha E, et al., Hepatology June 2013, online May 6, 2013 (ncbi.nlm.nih.gov) – looks like the source of at least some articles with projections. The abstract, conclusion, and much of the rest are readable by non-academics, although there’s a high density of facts and figures. It’s easy enough to get the general idea from four charts showing various peaks. Bearing in mind the title (so the costs should be HCV-related, and U.S. only), paraphrased from the paper –

      Prevalence of compensated cirrhosis was expected to peak at 626,500 in 2015.


      Prevalence of decompensated cirrhosis was expected to peak at 107,400 in 2019.


      The annual cost of compensated cirrhosis of the liver was expected to peak at $1.9 billion in 2022.


      The annual cost of decompensated cirrhosis of the liver was expected to peak at $4.2 billion in 2025.


    The annual cost of chronic hepatitis C (CHC) was expected to peak at $1.4 billion in 2025.

(Technically, prevalence should be a proportion, but I’m not trying to write a Phd thesis.)

I probably shouldn’t add peaks for different years, but I have, and it comes to $7.5 billion. Those projections may be out of date already, but it’s hard to be sure because I have not found figures which are higher, more recent, and confined to the same categories. For comparison, a chart near the top of this piece shows Sovaldi sold $10,283 million, and Harvoni sold $2,127 million, in 2014. The sales will be heavily U.S. weighted, and Harvoni was not on sale for long. While prices have come down, access has been improved.

The article “New hepatitis C drugs predicted to place a dramatic financial strain on health care system” University of Texas M. D. Anderson Cancer Center, March 16, 2015 (sciencedaily.com), gives a projection which amounts to an average cost of $27.2 billion per year over the next five years, for hepatitis C drugs. Another source projected spending on hepatitis C drugs in the U.S. to reach over $20 billion in 2018, getting there with growth over 6% p.a., find the link “At $84,000 Gilead Hepatitis C Drug Sets Off Payer Revolt”, below (the info is under the heading “Increasing Costs”).

The figures in the bullet points below are from “Gilead Sciences (GILD) CFO Robin Washington Presents at RBC Healthcare Conference (Transcript)” Feb. 27, 2015 (on www.seekingalpha.com). I’m not sure what all the figures mean, for example the prevalence in Italy is probably all cases of HCV infection, but it was not specified.

• Patients treated in 2014 in the United States with either Sovaldi or Harvoni, 140,000.

• Expected to be treated in the U.S. in 2015, under 250,000 (240,000 and 250,000 were also mentioned).

• Diagnosed patients in the U.S., 1.6 million (that would last 6.4 years if 250,000 were treated per year, without counting new cases).

• Undiagnosed cases in the U.S, 2 million, but prevalence is estimated at over four million (which is more than the sum of diagnosed and undiagnosed cases, 1.6 + 2 million = 3.6 million).

(It’s also been claimed that 3.2 million Americans are infected with HCV, and more than three quarters of them develop chronic infection, which can be without symptoms until damage to the liver causes them. Find the link “FDA Approves Olysio (simeprevir) in Combination with Sofosbuvir for Genotype 1 Chronic Hepatitis C Infection”, below.)

Advertising and education could help to get more cases diagnosed. The current attitude in the medical profession is that early-stage liver disease does not need treatment urgently, so there will be a delay between diagnosis and treatment, and not every case is likely to be treated.

The limited number of doctors and the patients they can see is also a ceiling on the rate at which diagnosed patients can be treated.

The size of the market puts a ceiling on the opportunity, and competitors will take at least some market share.

While not stated, the numbers above seem to be U.S. only.

• Expected to be treated in 2015 in Europe, 100,000.

• Prevalence in Italy, 1.5 million (unusually high, and prevalence could be above average in other southern European countries).

• Run rate in Europe, $2 billion per year. The run rate probably assumes that sales are level with the most relevant recent period, and is not a projection. It’s based on sales in only two countries, France and Germany, Sovaldi only (no Harvoni sales), with restrictions that are likely to become looser because prices have been agreed.
Agreements in Europe vary between countries, and some are confidential. In Europe, lower prices result from higher volume, rather than better access. Until the data is in, it’s not easy for Gilead to give an average European price, probably for any product with potentially high volume, and it’s harder for anyone else, due to the confidential agreements.

The suggestion that prices in Europe would be 65% to 70% of the U.S. price was not “totally out of the ballpark” according to the CFO.

• Number of HCV patients in Japan, a million. (The article “A No-Nonsense Projection Of Gilead In 2015” by Anthony Clarke, Mar. 18, 2015 (seekingalpha.com), has a lot about Japan. See also “Japan’s Ministry of Health, Labour and Welfare Approves Gilead’s Sovaldi® (sofosbuvir) for the Treatment of Genotype 2 Chronic Hepatitis C” Mar. 26, 2015 (gilead.com).)

• Proportion of genotype 2 and 3 patients in Japan, 30%. Harvoni won’t be prescribed for genotype-2, but Sovaldi could be.

    “Marketing applications for sofosbuvir and the fixed-dose combination of ledipasvir and sofosbuvir are pending in Japan.” (10-K for 2014)

(I’ll remind that sofosbuvir is known commercially as Sovaldi, it’s one of the two ingredients in Harvoni, and Harvoni targets HCV genotype 1.)

According to the analyst Michael Yee, genotype 1 represents the other 70% of the HCV market in Japan. Bristol-Myers Squibb got there first with a product that’s only good for genotype 1, with about a quarter of a billion sales (USD) in a quarter.

Revenue from Japan (for HCV) is likely to start near the end of 2015.

BTW I don’t usually have much praise for analysts, but Michael Yee asked some pertinent questions about how hepatitis C sales will trend over several years.

A ‘promising’ HCV vaccine

A “Promising new HCV vaccine” by Audrey Lin, 11 November 2014 (applevir.org), seems some way off.

The genetic diversity of HCV is a problem mentioned in the paper. Some people with HCV spontaneously clear the virus, and the vaccine is based on the T-cell response seen when that occurs. 15 healthy volunteers showed the right kind of T-cell response, and the vaccine appeared safe. The author says the vaccine “shows promise”.

Hepatitis B (HBV)

Worldwide, about 240 million people have chronic HBV, see Hepatitis B by Francisco Averhoff (Centers for Disease Control and Prevention).

Viread is used to treat HIV, but it’s also listed under “Liver diseases” and is …

    “dosed once a day for the treatment of chronic HBV in adults with compensated and decompensated liver disease.” (10-K for 2014)

It’s licensed to GlaxoSmithKline Inc. (GSK) for chronic HBV in China, Japan and Saudi Arabia.

Hepsera is listed under “Liver diseases” and is dosed once a day to treat chronic HBV, in patients 12 years old or older. It’s licensed to GSK for the treatment of chronic HBV in Asia Pacific, Latin America and some other places.

The pipeline includes –

      TAF (nucleotide reverse transcriptase inhibitor) (in phase 3)


      (Phase 3 has been completed for TAF for HIV.)


      GS-4774 (Tarmogen T cell immunity stimulator) (in phase 2)


    GS-9620 (TLR-7 agonist) (in phase 2)

Apart from the phase 3 results for TAF for HIV, the info is from Gilead’s Q4 2014 earnings slides PDF.

I don’t know what proportion of HBV patients could be treated with Gilead’s approved or candidate products.

HIV numbers

See “The HIV/AIDS Epidemic in the United States” Apr 07, 2014 (kff.org). Over 1.1 million people are infected in the U.S. New infections peaked in the 1980s, but have remained stable at around 50,000 for over a decade.

The WHO puts the number of people with HIV/AIDS worldwide at 35 million, in 2013 – “HIV/AIDS” (who.int)

From “UNAIDS reports that reaching Fast-Track Targets will avert nearly 28 million new HIV infections and end the AIDS epidemic as a global health threat by 2030” 18 November 2014 (unaids.org) –

    “We have bent the trajectory of the epidemic,” said Michel Sidibé, Executive Director of UNAIDS. “Now we have five years to break it for good or risk the epidemic rebounding out of control.”

Fast-tracked competitors

The FDA can give a drug in development either “Fast Track” status, or a “Breakthrough Therapy Designation“. In each case, the FDA will expedite the approvals process, although it depends on the company not delaying its communications with the FDA. The links give clear explanations. Investors tend to say that a treatment has been “fast-tracked” if it’s actually been given the breakthrough designation.

The criteria in the links for both designations do not include increasing competition. I can’t say “The FDA will never fast-track a product in order to increase competition.”, but I know of no evidence beyond the fact that most approvals probably hurt a competitor.

Two competing hepatitis C products have been fast-tracked, and then taken off the fast track, due to the existence of four licensed products. See “Merck’s hep C drug no longer a ‘breakthrough’” by Thomas Meek, 5th February 2015, (pmlive.com), where the list of four new treatments starts with two from Gilead, and see “BMS follows Merck as glut of HCV drugs leads to loss of fast-track status” By Dan Stanton+, 11-Feb-2015 (in-pharmatechnologist.com). The ‘glut’ is the same four products as in the previous link.

Pricing in the U.S. and other developed countries

The piece “US pharmacy deals could cut costs of AbbVie and Gilead’s HCV treatments” By Dan Stanton+, 06-Jan-2015 (in-pharmatechnologist.com), allows the quote –

    “Gilead and AbbVie’s exclusive deals with payers CVS and Express Scripts could help cut the cost of the new class of treatments for America’s three million Hepatitis C sufferers.”

Governments don’t like high prices for drugs. The tax in France (later) was an open measure to claw back cash one way or another. It’s normal for drugs to start at a higher average price and sell mostly to private buyers, and for the price to come down as more sales are made to public agencies, and as agreements are made with the large buyers. Management have stated in earnings calls that the process has been accelerated (a physicist would say no, it’s been faster). The average price is also affected as sales build in other countries.

Typically, in return for rebates (from Gilead), restrictions can be eased, such as how badly diseased a liver has to be before an insurer pays for the relevant medication. (Find “The insurance companies that Gilead” for a comment by rational2168 under the Q4 2014 earnings call transcript, and there are other well-informed comments there).

This gives a flavor of the opposition to Gilead’s early pricing – “Activists Hold Die-In to Protest High Price of Gilead’s Hepatitis C Drug” by Michel Sidibé, UNAIDS, July 24, 2014 (treatmentactiongroup.org). The article grives a price range of US$84,000 to $168,000 for the Sovaldi regimen in the United States. Less committed sources stick with $84,000 – “At $84,000 Gilead Hepatitis C Drug Sets Off Payer Revolt” by Drew Armstrong, January 27, 2014 (bloomberg.com). For comparison – “U.S. FDA approves AbbVie hepatitis C drug, costs $83,319 for 12 weeks” by Caroline Humer, Mon Dec 22, 2014 (reuters.com). See also “Payers hit back at Gilead for $94,500 price tag on brand-new hep C combo pill” by Carly Helfand, October 13, 2014 (fiercepharma.com).

About interest from the U.S. Senate –

    “In July 2014, we received a letter from the U.S. Senate Committee on Finance requesting information and supporting documentation from us related to Sovaldi and the pricing of Sovaldi in the United States. The letter raised concerns about our approach to pricing Sovaldi, its affordability and its impact on federal government spending and public health. We are cooperating with the inquiries. It is both costly and time consuming for us to comply with these inquiries. We cannot predict the outcome.” (10-K)

See “US lawmakers question price of Gilead’s hepatitis C drug Sovaldi” by: Joe Barber, July 11th, 2014 (firstwordpharma.com).

That might not be much of an issue now, as I could not find “letter”, “Senate” or “Committee” in the earnings call transcript, or the RBC or Cowen & Co conference transcripts, although there might not have been much point in asking about it before any further news.

The media frequently highlighted the “$1,000 a day” or “$1,000 per pill” price tags (google – Gilead $1,000 a pill). A cure is better than a lifetime palliative, and requires fewer pills. A short course of treatment is better and requires fewer pills. A single pill is better than mutliple pills, and requires fewer pills. Once per day is better than more than once per day, and requires fewer pills. Pills are better than most other methods of treatment (exceptions, such as acidic pills given to elderly patients, don’t seem to be relevant here). The total cost of a course of treatment matters, as well as all the benefits including the benefits of convenient administration. “$1,000 per pill” does not reflect those considerations.

While initial prices may have been too high, it’s normal for the price to come down. There’s a third factor for Harvoni – volumes were surprisingly high, or shockingly high for the the PBMs (Pharmacy Benefit Managers) who had to pay, so they were keen to get rebates, and in return, Gilead got improved access (meaning Harvoni was available to a wider set of patients). I don’t go into the ability of PBMs to pass on the cost, because the issue here is not who bears the ultimate cost, and PBMs don’t say “never mind, we’ll just pass the cost on”, they resist high prices.

Price variation in the U.S.A.

There is not usually a single price for a drug. Pharmacy Benefit Managers (PBMs) like Express Scripts (ESRX) buy in bulk and negotiate discounts. They can get a bigger discount in return for an exclusive agreement, to buy only one company’s product for a particular condition. Some patients with the condition could have a variation which means they can’t be prescribed the product with the exclusive agreement, and the buyers have to buy from a pharma company which won’t be happy about being excluded. The excluded company will not want to give any discount on such sales (and would like to charge as much as possible). The resulting price will be higher than the price charged where the company has agreed a lower price in return for volume. These links have information about exclusive deals, but not about the revenge of excluded companies – “Sorry, Gilead. AbbVie cuts exclusive hep C deal with Express Scripts” by Tracy Staton, December 22, 2014 (fiercepharma.com). That’s fairly anti-Gilead, and for balance there’s “How Drug Company Gilead Outpaces Its Competitors—And Common Diseases” by J.J. McCorvey (fastcompany.com) which also mentions Express Scripts. Gilead’s CFO Robin Washington said –

    “If you take a look at the large PBMs, nine out of 10 have ultimately chosen Harvoni. And of those nine, eight have chosen exclusive.” (seekingalpha.com)

For the source and a link, find “RBC Healthcare Conference (Transcript)” above.

It’s possible that sometimes when exclusive deals are referred to, that might be short for “preferred or exclusive formulary status”, a phrase used in the link “The Hepatitis C Scorecard: Gilead is Trouncing AbbVie, but at a Price” (above). I can’t prove that any use of “exclusive” ought to have been “preferred or exclusive”.

So I can write more about price variation, I’ll assume here that Gilead’s IP is rock-solid – If a competitor sells a combination which includes a Gilead product, the combination could cannibalize the product’s sales. Gilead’s management would have to be crazy to agree a discount big enough to make the total revenue smaller, the more of the competitor’s combination is sold. Gilead could agree a discount if the combination gained access to patients, if the cannibalization of Gilead’s sales was low enough or non-existent. That’s another kind of case where pricing can be at the high end. When two companies use each other’s products in combinations, the terms are more likely to be reasonable, to the extent that the relationship is equal. In such cases the pricing is likely to be closer to the pricing that a single company would choose based on normal commercial factors.

For an example of a competitor using a Gilead product in a combination, see “FDA Approves Olysio (simeprevir) in Combination with Sofosbuvir for Genotype 1 Chronic Hepatitis C Infection” Nov. 5, 2014 (drugs.com). Olysio / simeprevir belongs to Janssen Therapeutics. Gilead’s 10-K mentions the drug at the end of …

    “Our HCV products, Sovaldi and Harvoni, compete with a product marketed by AbbVie Inc. (Abbvie) and Janssen R&D Ireland’s Olysio (simeprevir) in the United States.”

… under “We face significant competition.”.

The relationship is reversed for Gilead’s HIV combo Complera/Eviplera, which includes a Janssen product.

    “Complera/Eviplera is an oral formulation dosed once a day for the treatment of HIV-1 infection in adults. The product, marketed in the United States as Complera and in Europe as Eviplera, is our second complete single tablet regimen for the treatment of HIV and is a fixed-dose combination of our antiretroviral medications, Viread and Emtriva, and Janssen’s non-nucleoside reverse transcriptase inhibitor, Edurant (rilpivirine).”

The 10-K lists Janssen under “Commercial Collaborations”, as well as naming them as a competitor. Janssen are owned by Johnson & Johnson.

I’ll repeat here that government agencies pay less.

About guidance, the CEO said –

    “What we have in there is the range of different prices depending on the mix of private to public and there are a range of different discounts offered across all those areas.” from the Seeking Alpha transcript “Gilead Sciences’ (GILD) CEO John Martin on Q4 2014 Results – Earnings Call Transcript”, linked to above.

From the same transcript, about “gross to net” –

    “We expect our 2015 growth to net adjustments for our HCV products in the United States to be approximately 46% or a little more than double of that where we ended 2014 which was around 22%.”

The 46% overall discount is sometimes called “Gross to net”, where “gross” is at the list price and “net” is net of rebates or discounts. “growth to net” in the quote looks like a transcription error.

The effect of exclusive deals

The exclusive deals that Gilead and Abbvie have signed with the major PBMs don’t seem to leave much room in the U.S. market for treatments in other companies’ pipelines (find “Merck’s HCV pipeline” and “Achillion’s HCV pipeline”, above). I don’t know how long the agreements last, but I”d guess that anything much more than a year or two would be anti-competitive, because it would deny patients the benefit of innovation from other companies. Gilead have stated that they prefer letting doctors choose, but they can’t be expected to refuse exclusive agreements when that’s what the PBMs want, and when the giant Express Scripts signed an exclusive agreement with a competitor.

One reason for the PBMs’ enthusiasm for exclusive deals in this area may be that the drugs work, and they are safe, leaving limited room for improvement, even though Gilead’s liver disease pipeline is aimed at doing just that.

Obviously a U.S. deal does not affect sales in the rest of the world. If the U.S. market is sewn-up for a while, it does not necessarily mean that excluded companies have poor prospects in HCV, although the U.S. is a major market and it’s expected to peak.

The TRIPS agreement

The Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS), is generally what you’d expect from the name. The HIV/AIDS epidemic in Africa prompted some loosening of IP protection to allow access to essential medicines. A modification in 2003 allowed exports from one developing country to another, with restrictions such as packaging which is clearly different from the packaging used in developed countries. Those simple facts can cause complications for pharma companies and give rise to financial journalism of the kind light on nuance.

Production for low-price sales

Gilead can’t stop unauthorized production in Bangladesh and Egypt, because the World Trade Organization allows the non-enforcement of patents in some poor countries. Authorized production in India is sold at much lower prices than in the U.S., and is authorized for sale into agreed countries (poor ones). My guess is that unauthorized production in Bangladesh would leak into India if the price in India was much higher. In any case, India refused to grant a patent for Sovaldi (Gilead will appeal). India also has a big problem with counterfeit drugs.

See “$10 version of Sovaldi available in Bangladesh” by Douglas W. House, SA News Editor, Mar 9 2015 (seekingalpha.com), and Indian drug firm cleared to sell generic sofosbuvir” by Douglas W. House, SA News Editor, Mar 12 2015, (seekingalpha.com/news).

I don’t mean to imply anything about the Indian companies Gilead have agreements with, but it’s worth knowing about the problems in India. See India becomes a hub for fake medicines on safemedicinesindia (not dated), and if you can bear the page-junk, “Is your medicine a fake? Government report warns counterfeit drugs are flooding India” by Neetu Chandra, March 5, 2014 (dailymail.co.uk), which includes the claim that India has over 10,000 drugs manufacturers.

This looks exaggerated – “How India’s Patent Office Destroyed Gilead’s Global Game Plan” by Bruce Einhorn, January 15, 2015 (bloomberg.com). The most credible claim in the article is probably that India’s ruling will help challenges to Gilead’s Sofosbuvir patent in other countries. IMO courts and agencies in developed countries will not take a lead from India. No block-buster drug is likely to be sold at developed country prices in developing countries, by any company, and yet it seems to be big news when Gilead don’t achieve that. Bloomberg say Bruce Einhorn is an “Asia regional editor” and was an “Asia technology correspondent” (you can check the frequency and variety of his article titles here.)

I suggest finding the comment by Ptatty which mentions “TRIPS” under “Gilead Sciences Inc. Faces An Uncertain Future After Patent Loss In India” by Rami Alsamaraee, Mar. 30, 2015 (seekingalpha.com).

Overseas online pharmacies

The sellers that don’t abide by the law in the country they operate from are likely to supply sub-standard or dangerous pills. I suggest reading Wikipedia’s page or finding your own source for more detail.

Wikipedia describes verification programs. This is one of them – Verified Internet Pharmacy Practice Sites (VIPPS) program. When I put “h t t p : / / w w w.drugs******.com” into the box and clicked “Verify” I got “This pharmacy is not in the VIPPS database. Please report this occurrence to NABP by using our feedback form.”. (The spaces are so the URL won’t work as a link, and the asterisks are because I don’t want to publicize the drug seller.)

This story suggests there were allegations in China that Alibaba’s employees allowed fake drugs to be sold. “Chinese square off against Alibaba in palace intrigue as online drug sales loom” by EJ Lane, February 2, 2015 (fiercepharma.com). The story is vague, because it avoids saying directly that the fakes included drugs, or even that sales of fake drugs were alleged, yet “drug” occurs 21 times and the story is on fiercepharma.com. It isn’t hard to google-up things like “High Quality Sofosbuvir API/ Purity 99% Sofosbuvir ( sovaldi )” on alibaba.com. For ledipasvir, one result on Alibaba quoted “US $ 10,000 – 50,000 / Gram”, while a “Verified Supplier” quoted “US $ 1 – 100 / Kilogram” for what seems to be 99% pure ledipasvir in powder form, from any port in China. I don’t know how fussy the supplier is about who they sell to (I could guess). Some of Gilead’s HIV drugs seem to be on sale, or at least intermediates for them. I’d appreciate comments here because I’m not sure how to interpret the offers on Alibaba, but on the face of it, the active ingredients are made and sold at low cost in China.

Opinion on the low-cost trade

Everything from the problems patenting sofosbuvir in India to unauthorized cross-border trade is not special to Gilead. Instead I see an unresolvable tension between the need for pharma companies to have an incentive to develop drugs, and patients who desparately need a cure and can’t afford it, as well as other patients and other parties who want to keep costs down. The tension creates a suitable environment for generics companies, lawyers, online pharmacies of varying legitimacy, etc. A crucial factor is that the costs are both up-front and intellectual in nature, so there’s little up-front cost for copyists.

Gilead in France

See “France uses tax to put pressure on hepatitis C drug prices – (Daily Mail via NewsPoints Desk)” September 30th, 2014 (firstwordpharma.com).

It’s a concern because there doesn’t seem to be any downside for France, which other countries are likely to notice, and unlike the rebates in the U.S., there’s no volume or increased access for Gilead in return for the tax.

Tax in the U.S.A. and overseas

See “Gilead Avoids Billions in U.S. Taxes on Its $1,000-a-Pill Drug – (Bloomberg via NewsPoints Desk)” February 26th, 2015 (firstwordpharma.com).

Info about prescriptions

On the blog site “Gild – Gilead Science Shareholders” (gileadscienceshareholder.blogspot.co.uk), find “GILD Harvoni’s scripts were”, and you’ll see a list of weekly figures for US prescriptions. As at March 13, 2015, the figures show a steady rise for the year so far. “nrx” means new prescriptions, and I’d guess “trx” means total prescriptions (new plus repeat prescriptions).

The sources are “Symphony/BBG”, or Symphony Health Solutions and Bloomberg. I don’t know who their sources are, and I would not assume that every body gives them the data they would like to have. I expect that every prescription counted was real, but I would not assume that all prescriptions were counted. The conservative approach is to not assume that Gilead’s U.S. prescriptions are much more than reported (at least, not without a good reason), while not assuming that low numbers for a competitor are accurate. So long as the exclusions stay the same, a rise in the weekly figures is very like to reflect a real rise in the U.S. total. I hope that someone who knows more about it can simplify my qualifying statements.

See also the “BMD Asset Management and Research” instablog (on seekingalpha.com).


The employee reviews on Glassdoor can give a valuable insight into a company, although employees are no more unbiased than other stakeholders, and the “disgruntled employee” is common enough for the adjective to have become fairly standard. Unfortunately, I can only get the UK version, and I suggest checking the US version if you can. The score I see is very nearly three whole stars out of a possible five.

Generally, the drug devlopment side is praised. There’s much complaint about the work/life balance (which is not unusual, but it seems to be worse than average). There’s one low opinion of each of these – the commercial side, the IT, and the bureaucracy. It’s worth finding the review which contains “Little company syndrome”. The most severe criticism includes “turf fights”. The lean model is blamed for demanding too much from staff. It’s reported that staff changed tasks fairly frequently, but it was not said to be excessive or reduce productivity.

Employee reviews on indeed.com give an average of four stars (out of five), and were mostly very positive. Reviews on Indeed seemed more effusive and less critical of management, but I haven’t compared reviews from the two sites in any systematic way.

A bear’s view, and insider deals

This is bearish – “Forget Gilead Sciences (GILD), Buy These Biotech Stocks Instead” by Zacks Research Staff, March 06, 2015 (zacks.com). The EVP and a director have recently sold over $700,000 worth of shares, and earnings estimates have gone down.

A director bought nearly $1 million worth of shares on February 20, 2015, see “Gilead insider buys 10000 Shares“. As Peter Lynch said in “One up on Wall Street”, there are many reasons why an insider might sell shares in the company, but there’s only one reason to buy.

Michael Yee and RBC Capital

I noticed Michael Yee’s questions were pertinent and unusually relevant to the long term in the RBC Healthcare Conference. Michael Yee of RBC Capital is in tipranks‘ top 5% of analysts. He has rated Gilead more times than he’s rated any other company. I’ll just say the number is in double figures but under 20, and his performance is likely to have been assessed over a few years at least. The performance of each rating is based on returns over the following year.

Before 2014 results were out, RBC were reiterating “outperform”. Soon after the results – “Gilead (GILD) Price Target Lowered to $118 at RBC Capital” February 4, 2015 (streetinsider.com), although “outperform” was maintained. Michael Yee believes Gilead’s guidance is conservative, see “Bigger drug discounts put question mark over Gilead’s stellar run” by Reuters, Fortune Editors, February 4, 2015 (smarteranalyst.com).

On Tipranks I noticed a buy recommendation by Michael Yee for Uni-Pixel (UNXL) from two years ago. They are a tiny company that were developing touchscreens. There was much bitter argument about the company on Seeking Alpha, with serious accusations levelled at management (I think the management has been mostly replaced, but I stopped following the company). Two years ago, a short term profit could have been made, but UNXL were not a safe company to hold for one or two years. I also saw a ‘hold’ for Dendreon Corp. (DNDN) two years ago, and they went bankrupt. He may be weak at assessing some major risks, or maybe his outperformance was only possible because he learned from experience. Michael Yee’s performance is good relative to other analysts, but I saw no info about performance relative to sector or market indexes.

Less factual …

My piece – Gilead Sciences – highlights, opinions and unconfirmed points (kitchensinkinvestor.wordpress.com).

Last point about Gilead

Management have delivered.

Seeking Alpha transcripts quoted from

“Gilead Sciences’ (GILD) Management Presents at Cowen & Company 35th Annual Health Care Conference” Mar. 3, 2015 (www.seekingalpha.com)
Words: 19

“Gilead Sciences (GILD) CFO Robin Washington Presents at RBC Healthcare Conference (Transcript)” Feb. 27, 2015 (www.seekingalpha.com)
Words: 26

“Gilead Sciences’ (GILD) CEO John Martin on Q4 2014 Results – Earnings Call Transcript” Feb. 3, 2015 (www.seekingalpha.com)
Words: 120

“AbbVie’s (ABBV) CEO Richard Gonzalez on Q4 2014 Results – Earnings Call Transcript” Jan. 30, 2015 (www.seekingalpha.com)
Words: 63

Total words: 228

Thanks SA

With thanks to Seeking Alpha for their policy about quoting from transcripts, which can be found at the end of the transcript. I hope they don’t mind me quoting from four of them.

That’s all

Thank you for reading this.

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