This content is from: Portfolio

Is Tech's Next Hot Thing a Lukewarm Investment?

Systems such as the Nest thermostat may change the way millions of homes run—but they won't change much for institutional investors.

  • Craig Mellow

It seemed like a match made in high-tech heaven. Nest Labs was hatched in 2010 in a Palo Alto, California, garage by Tony Fadell, a former Apple executive who played key roles in developing the iPod and the iPhone. Fadell’s notion of the next big thing was an intelligent, communicative thermostat that could launch the era of the so-called smart home. He quickly gathered angel funding, led by legendary Silicon Valley venture capital firm Kleiner Perkins Caufield & Byers. In 2014 the investors sold Nest to Google for a cool $3.2 billion.

“We felt it was a fair price because Google was getting arguably the best hardware team on the planet at the time,” says Rob Coneybeer, co-founder of Shasta Ventures, which joined Kleiner Perkins in Nest’s A-round funding.

Marrying that team to Google’s networking dominance and enormous financial resources to redesign the way we all live — what could go wrong? A lot, it turns out. Fadell, an alpha executive who acknowledged to the New York Times that he “pushes people beyond what they thought they could achieve,” had an ugly public spat with one key subordinate, then semipublic friction with a new chief financial officer at Google (formally renamed Alphabet Inc.), who pressed him to shorten Nest’s so-called runway to profitability. Two years after the acquisition, he was ready to quit. He left the company in June.

Meanwhile, Nest experienced bugs in its second big product, a smoke detector that had to be recalled when regulators found it could be disabled accidentally. While the first mover stumbled, competitors including Amazon.com, Apple and Samsung Electronics Co. woke up to the potential of the smart home. The current consensus among the technorati is that Amazon has jumped ahead in this potential multibillion-dollar market by inviting the outside world to build hardware around its Alexa voice-command system.

“The market is still in a very nascent and fragmented state, but Amazon is the dominant player today,” says Werner Goertz, who covers personal technology for tech consulting firm Gartner.

Nest and its parent, Alphabet, are hardly out of the running on the smart home. But Nest’s tumultuous first six years are a cautionary tale for institutional investors seeking return from unfolding technological wonders. While Silicon Valley remains a seemingly inexhaustible well of innovation and implementation, portfolio investors struggle to catch the lightning of that innovation in a bottle of stable profitability, whether directly through innovators’ share offerings or indirectly through acquisition by existing public companies like Alphabet. There are so many ways for the brightest to stumble — through the vagaries of visionaries’ egos, the relentless efforts of rival geniuses, or simple wrong guesses in an endlessly evolving domain.

Venture capitalists can live with multiple failures thanks to the huge killings they make from their successes. Institutional investors, which access companies later in their development cycles, cannot. “The economics of my business allow me to succeed less than 20 percent of the time and still deliver extraordinary returns,” says Randy Komisar, the Kleiner Perkins partner who oversaw his firm’s stake in Nest. “Investors in public markets just can’t afford that.”

Kleiner Perkins was the first and largest private investor in Nest, but Komisar admits to being a bit underwhelmed when Tony Fadell first pitched him. “After the iPod and iPhone, I thought he could do very grand things,” he says. “When he presented a round thermostat, I was a bit disappointed.”

By 2010, Fadell, now 47, had a reputation as one of the Valley’s most potent secret weapons. Raised outside Detroit, he had headed west after graduating from the University of Michigan in 1991 with a computer engineering degree. Fadell got a job at General Magic, a wireless communications pioneer founded by renegade Apple engineers. His colleagues there included established tech legends like Andy Hertzfeld, a founding father of the Macintosh personal computer, and legends-to-be like Pierre Omidyar, who not long afterward started eBay.

“Tony was a leader fresh out of undergrad,” recalls Peter Nieh, another General Magic alumnus, who two decades later invested in Nest as a partner at Lightspeed Venture Partners. “He was an incredible engineer combined with a provocative thinker. If Tony was starting a company to do food trucks, we would have backed him.” Fadell himself declined to be interviewed for this article.

Fadell left General Magic after its 1995 IPO but continued to focus on the budding field of networked devices. He created a business unit to focus on palmtop computers for Dutch electronics giant Philips, then in 1999 formed a company called Fuse. There he tinkered with a portable digital music player to capitalize on the burgeoning MP3 file-sharing movement. (Free-music pioneer Napster launched that same year.) Fuse failed to raise sufficient venture capital funding but found a home within Apple, where Steve Jobs made Fadell chief of the iPod group in 2001.

Over the next seven years, Fadell proved his mettle at Apple as both an innovator and an administrator, overseeing massive hardware development efforts for the iPod and early generations of the iPhone.

“I saw Tony drive teams on time and on budget over very tight schedules for dozens of product versions,” Komisar says. “The work he did at Apple was critical in transforming it from a computer maker to a consumer products company.”

At Nest, Fadell soon convinced Komisar and his other investors that his little round thermostat held the seeds of another lucrative revolution. It was a “Trojan horse,” in Komisar’s phrase, for a rethinking of the world’s living spaces, spurred by cutting-edge artificial intelligence and networking science. Smart home is the domestic front of the much-touted Internet of Things (IoT). Sensors that allow inanimate objects to see what is around them, machine learning algorithms that teach them how to sort out what they see, and communications links to other, similarly clever objects — all are supposed to be hurtling us toward a world of self-repairing cars and factory-floor robots that order their own inventory, to name two examples.

Some early smart-home products may seem whimsical, like the Samsung Family Hub fridge — unveiled this year and priced at $5,000 — that can report remotely when its owner is running low on milk. But an intelligent thermostat like Nest’s can have a significant, immediate impact on energy use and costs. The device’s sensors can, among other abilities, correct for the effect of winter sunlight warming a thermostat while the rest of the house stays cold. Constant communication with a utility’s computers allows the homeowner to draw energy in cheaper, off-peak periods and save it for the peaks.

Fadell leveraged his Apple experience to make his device simple and attractive, well aware that 90 percent of homeowners do not bother to program their thermostats because the process is too complicated. “Tony and his team had a complete, maniacal focus on this single product,” investor Coneybeer says. “They bought hundreds of thermostats and put them up on a fake wall in the office. They spent hundreds of hours visiting people in their houses to see where the thermostats hung.”

Still, the real promise of Nest was the opportunity to set the protocols and standards that future smart-home inventions would conform to, as the iPhone did for the universe of mobile apps. Some of those applications are envisioned but not yet developed, Gartner’s Goertz says. These include smart-sprinkler systems that integrate soil moisture readings and weather forecasts to irrigate the garden more efficiently, and monitors for the elderly that can call for help if the wearers’ blood pressure spikes or they take a fall. Other innovations presumably remain unforeseen — as Fadell himself could not have foreseen Uber Technologies when he was helping to create the iPhone in the mid-2000s.

Nest started with a clear head start as the hub of this far-­reaching ecosystem. “It’s 20th-century thinking that you’re investing in companies and their products,” says Michael Schrage, an author on innovation and a research fellow at the MIT Center for Digital Business. “What you’re investing in now is great platforms.”

Fadell and his junior partner, Matt Rogers, who had worked on his team at Apple, did not let their venture capital investors down. Though sales figures remain confidential, the Nest thermostat moved out of the garage and into mass production by October 2011, and by now it is an established fixture on hardware store shelves. A second product, the Nest Protect smoke and carbon monoxide alarm, rolled out in October 2013. (One nifty feature: It shuts down its home’s boiler and furnace in the event of a perceived fire.) “They were performing like a Swiss clock,” Komisar recalls. “This was one of the fastest-growing product companies we ever had at Kleiner Perkins.”

Nest was not shopping for a buyer, Komisar and other investors say. But Fadell had an informal bridge to Google founders Larry Page and Sergey Brin via Bill Maris, then chief of the company’s Google Ventures investment arm, which had taken an early stake in Nest. The high-powered trio began to schmooze periodically as Nest tested its market muscles. Buyout talks heated up toward the end of 2013.

Despite the $3.2 billion enticement, Nest’s backers, including Maris, say they had serious qualms about selling. “I thought Google got a screaming deal when they got Nest,” Maris says. “I would have liked to see the company stay private.” (He left Google last summer, a few months after Fadell, claiming burnout after ten years and a desire to spend more time with his infant son.)

Fadell and Rogers were won over, however. Google announced the acquisition in January 2014 and added to the price tag in June of that year by paying $555 million for Dropcam, a maker of next-generation security cameras that after some fits and starts became Nest’s third product line.

Trouble started soon after Google’s takeover. The U.S. Consumer Product Safety Commission found a dangerous problem with Nest’s smoke alarms in April 2014, forcing the company to halt sales and recall 440,000 units the following month. The Dropcam acquisition brought in a second visionary — that company’s founder, Greg Duffy — who failed to gel with Fadell. Duffy left Nest after eight months, and he and Fadell subsequently exchanged insults via the energetic Silicon Valley press.

Fadell started the fracas by telling online publication The Information that “a lot of the [Dropcam] employees were not as good as we hoped.” Duffy retaliated by telling Business Insider he had called Fadell a “tyrant bureaucrat.” He elaborated in a post on the Medium website: “The current leadership at Nest . . . seems to be fetishizing only the most superfluous and negative traits of their mentors.”

Some outside observers see Fadell’s prickly personality as a $3.2 billion accident waiting to happen. “This was a completely logical acquisition for Google in terms of competencies and capabilities,” MIT’s Schrage says. “But it was an unexpectedly problematic acquisition because personalities matter as much or more than strategy.”

Fadell’s admirers respond that his personality is part and parcel of his success. “When you want to drive for excellence, you can’t be Mr. Nice Guy,” Lightspeed’s Nieh says. “If you went into Tony’s office without thinking things through, he would hand you some body part on a platter.”

While the ego clashes took their toll, it became increasingly clear that smart-home products would wreak disruption only gradually. Replacing a thermostat, however sensible in the long run, was a less compelling priority for consumers than upgrading to an iPhone or summoning Uber instead of waiting for the bus. Just 6 percent of U.S. homes contain an Internet-connected device — a number that will creep up to 15 percent by 2021, according to the Economist. Gartner’s Goertz projects a $2 billion global market for smart-home hardware by 2020. That compares with current iPhone sales of well over $100 billion. “We’ve been talking about IoT and connected devices for many years now, but that vision has yet to materialize into a big enough market,” notes Gil Luria, director of research at technology-focused brokerage Wedbush Securities.

Aside from smart-home apps not being killer enough, putting houses online creates hacking threats. “Nobody is taking security seriously enough in this area,” says Rob Enderle, a closely followed independent tech analyst. “A few [denial of service] attacks and you could get into an IoT apocalypse.”

When Fadell and Rogers accepted Google’s offer, they assumed their new bosses would have patience for a long incubation aimed at owning the category when it eventually matured into a money spinner. The prototype was YouTube, which Google bought in 2006 but has, by most accounts, yet to produce a profit. (The company wraps YouTube’s financials in with those of its core search-driven advertising business.)

Brin and Page generously funded half a dozen other ambitious open-ended projects before Nest, in fields ranging from Google Glass to self-driving cars, medical robots, and fiber-optic cable. Techies applauded their enthusiasm. “Google is very liberal in throwing technology against the wall and seeing if it sticks,” Gartner’s Goertz says. But some securities analysts take a dimmer view of multibillion-dollar expenditures with no obvious focus or accountability. “Google’s acquisition history could be described as a four-year-old with sugar,” Enderle says. “Everything they have done since they have gone public has been an abysmal failure.” Google’s IPO was in 2004.

The founding duo seemed to heed investors’ rumblings in August 2015, when they announced the creation of Alphabet, a holding structure that would begin to separate the money machine of Google’s ad business from the company’s diverse venture projects; the latter were bunched in a division called Other Bets. Google watchers linked the decluttering to the arrival five months earlier of a new chief financial officer: Ruth Porat, a 28-year Wall Street veteran who came from the CFO’s chair at Morgan Stanley in New York.

The transition to Alphabet, completed in November 2015, made plain just how little the other bets had produced financially. The most recent quarterly results showed the division with $197 million in revenue (a mere 0.9 percent of Alphabet’s total turnover) and an $865 million loss. The company does not publish separate numbers for each of the bets, so Nest’s own P&L remains a matter of guesswork.

Porat set to work stanching the other bets’ red ink and asking pointed questions about when the long shots might reach a profitable destination. “The cost cutting is real and it’s driven by [Porat],” Alphabet chairman and ex–Google CEO Eric Schmidt told Fortune recently. “Before she was there, we had lost discipline.”

Investors love Porat’s firm hand. Alphabet shares have soared 40 percent since she came on board in March 2015, compared with a 15 percent rise in the most widely held diversified tech fund, the SPDR Technology Sector ETF (ticker symbol: XLK). But key personnel at the long-shot companies seem to be voting against that firm hand with their feet. Fadell made up his mind to leave last February, three months after Google became Alphabet, his friends say. He publicly ascribed his departure to the genius’s natural creative cycle. “I’m a guy who’s at the beginning of things,” he told the New York Times. “I don’t like to do maintenance mode.” He remains an adviser to Alphabet.

Fadell backer Komisar is blunter. “I believed that they would regret selling within two years, and Google changed its strategy one year and 11 months after they signed the deal,” he says. “Tony expected to have a very long time line.” More exits from Other Bets have followed Fadell’s. Google Ventures founder Maris tendered his resignation in August. Google Fiber boss Craig Barratt, a star entrepreneur in his own right, who sold his semiconductor maker, Atheros, to Qualcomm for $3.7 billion, left in October.

As internal politics slowed down Nest, its competitors accelerated their smart-home efforts, and futurists’ theories of how the ecosystem would develop shifted: For the moment, the consensus prognosis is a web of devices around a voice-responsive hub. Amazon looks to be on the cusp of this wave with the Echo speaker, which translates commands to its Alexa operating system. The Echo went on sale to the general public in June 2015.

“I believe absolutely that Alexa is turning out to be a better window into the home than the Nest–Dropcam approach,” MIT’s Schrage says. “It has a whole suite of APIs designed to facilitate the developer community. Who could have known this when Nest was acquired?” (API stands for “application programming interface,” tools that enable external vendors to build software around an industry standard.)

Alphabet is fighting back with Google Home, a speaker system released in November that integrates with the Google Assistant command system. But Echo’s 18-month head start spawned some 3,000 apps (which Amazon calls skills) linked to its hardware, compared with four on Google Home’s launch date, according to tech journal CNET. Nest, as a stand-alone unit, seems to have refocused its ambitions on key hardware spokes, leaving the race to develop a smart-home hub to its corporate parent. “We’re platform-agnostic and can work with Alexa,” Nest spokeswoman Kate Brinks says. “If you’re talking to consumers about what products to put in their home, they don’t say Amazon. They say Nest.”

To the technology elite, the problems that have beset Nest are ordinary, even necessary, elements in their self-appointed mission to change the way the world works. Charismatic founders like Fadell leave more often than they stay after selling out to reigning giants like Google. The reigning giants often stumble, allowing their relentless competitors to pounce. Billions may be spent fruitlessly while the next maniacal cell in the next garage is sowing seeds that will yield new tens of billions of dollars. None of this has dented insiders’ faith in the smart home, the Internet of things, or the magic of technology in general. “Big changes in tech always take a lot longer than we think, then make a bigger impact than we think,” Wedbush’s Luria says. “It was that way with the PC, the Internet, and social networking.”

Such cosmic reassurance is of little comfort to institutional investors, however. Venture capital and private equity firms, which scout for future disrupters in their infancies, may lose four out of five times and still win. Triumphant disrupters from previous waves, like Google, can afford to make some bad calls on the next wave. Alphabet booked $5.06 billion in net profit during the three months ended September 30, a 27 percent jump year-on-year — numbers that assuaged shareholders’ indignation about chaos in the Other Bets.

Portfolio investors’ position in the permanent technology revolution is less advantageous. In the best cases the exponential returns have been reaped further up the capital chain. “Most of the value is being created in the private market,” Luria observes. “Even Facebook and Google were already very big when they went public.”

In the worst cases — and there are many — equity investors or corporate acquirers are left with a meltdown after venture firms’ profits are safely in the bank. To notorious turn-of-century debacles like AOL and Boo.com, our own era is adding the sad histories of Fitbit, Groupon, and perhaps Twitter — all companies that moved the technology needle in exciting ways, then fizzled financially.

That does not mean diversified stock investors should avoid tech, broadly speaking. The SPDR sector ETF has outperformed wider markets over the past five years, rising by 85 percent, compared with 78 percent for the S&P 500 index. But the fund’s big holdings are in proven profit churners that dominate a more or less mature market: Apple, Microsoft Corp., Facebook, AT&T, and Alphabet itself. Chasing Silicon Valley’s latest visions, investors often buy into an expensive mirage.•