Fitbit Q1 16A – Forced hand.

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Fitbit is being forced to spend to stay ahead.

  • Fitbit reported good Q1 16A results but cut guidance in order to ramp up spending placing unrealistic expectations of profitability in H2 2016.
  • This is particularly worrying as there are clear signs that commoditisation is forcing the company to increase spending, hitting profits.
  • Q1 16A revenues / adj-EPS were $505m / $0.10 nicely ahead of consensus at $443m / $0.03 but EPS for the quarter ahead is going to be weak.
  • Q2 16E revenues are expected to be $565m-$585m ($575m midpoint) ahead of consensus at $533m but expectations of adj-EPS at $0.08-$0.11 are way below consensus of $0.26.
  • Gross margins are slipping as commoditisation creeps in but the real problem is OPEX.
  • Fitbit is right in that it needs to spend on R&D and sales and marketing to stay ahead of its rivals, but general and admin expenses (G&A) are a real worry.
  • In Q1 15A G&A expenses were $13.0m or 3.9% of sales but in Q1 16A they jumped to $35.7m or 7.1% of sales.
  • My threshold for G&A is 5% and this sudden elevation has all the hallmarks of indisciplined expansion.
  • This in turn makes me worry about the quality of the investments that the company is making in both R&D and sales and marketing.
  • If these investments do not produce results, then commoditisation will accelerate and gross margin will continue to decline hitting the already fragile profitability.
  • The good news is that Fitbit knows exactly what it has to do which is to increase the stickiness of its users through the refinement of its embryonic ecosystem.
  • This alone puts Fitbit miles ahead of GoPro when it comes to dealing with aggressive competition and slowing and saturated end markets.
  • When it comes to an ecosystem the key is the number of users and the degree to which they are engaged with one’s services.
  • Fitbit posted some encouraging figures at its 2015 year end results in January with 16.9m active users making up 59% of the registered user base.
  • These users were also more engaged with an average of 7.5 connections to other users compared to 4.9 at the end of 2014.
  • Unfortunately, Fitbit declined to update these figures leading me to believe that there was nothing particularly good to report.
  • This is concerning because if the investments that it is making in R&D and sales and marketing pay off, it is in user numbers and engagement that the results will be first seen.
  • Gross margin stabilisation and profits will then follow but it is in the ecosystem where the loyalty and preference will be generated that will give Fitbit pricing power.
  • Somewhat inexplicably, Fitbit also raised its adj-EPS guidance for the full year to $1.12 – $1.24 from $1.08-$1.20 meaning that to meet guidance Fitbit needs to generate 83% of its net profit in the last 6 months of the year.
  • Given the environment, this looks to be a very tall order and I suspect that there is a heavy cut to full year EPS guidance coming either in June or October.
  • My concerns around both the market for its products and its fiscal discipline lead me to believe that Fitbit could realistically generate adjusted EPS of $0.80 for the full year.
  • This leaves the company with a 2016E PER of 18.5x which is quite punchy for a company showing little profit growth and at high risk of commoditisation.
  • I would be more comfortable between $10-12 a share rather than the $14.90 that it is currently at but if forced to choose I would have this over GoPro.

Autonomous Auto – Men and dogs

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I see a shake out with only a handful surviving. 

  • Just as in 2011 when every man and his dog was building an app store, now everyone is trying to build an autonomous vehicle.
  • Just as it was with app stores and every other technology craze before it, only a very few are likely to succeed.
  • Google, Apple, Tesla, Baidu, Alibaba, Tencent, Uber, Lyft, Faraday Future, Didi Kuadi, Mobileye, LeEco as well as every company that already makes cars are all trying to come up with an autonomous car.
  • Of all of these, I think Google is the most advanced as it has been working on self-driving cars the longest and I believe it has the best machine learning and artificial intelligence heritage.
  • I have long been of the opinion that autonomous cars are going to take far longer than anyone expected to become mainstream (see here).
  • Unfortunately, the internet industry has taken the example of the time that it took to become a global force and unrealistically applied the same logic to autonomous cars.
  • The automobile industry is heavily regulated both in terms of its products and how those products are used by consumers.
  • Hence, there is every sign that the technology will be ready long before the market is giving plenty of time for a shakeout before the real roll out begins (see here).
  • In order for an autonomous solution to work a number of things need to come together.
    • First. A highly accurate map (although some argue that highly accurate sensing is enough).
    • The current maps are not accurate enough and so the mapping companies are going through the process of re-mapping the world in high definition.
    • This is an expensive process and I suspect that only Google, HERE and Apple (if it so desires) have the means necessary to do this.
    • China is likely to be re-mapped by Chinese companies and remain a law unto itself.
    • Second. A highly accurate positioning and sensing system for the car itself.
    • A high definition map is useless unless the car knows exactly where it is and where the obstacles are and the GPS system in use today is not nearly accurate enough.
    • Third. A sophisticated artificial intelligence system that is capable of dealing with unpredictable events that will be caused with non-autonomous vehicles sharing the road.
  • Furthermore, all of these systems will need to be somewhat compatible with each other as at some point they will need to communicate with server based traffic management systems.
  • This is because there are huge savings to be made in journey times if there is a centralised system that is aware of where all the vehicles are and where they are going and can manage the flow accordingly.
  • I suspect that there will be a handful of autonomous driving systems that make it with the vast majority falling by the wayside.
  • Those that don’t have it will have to licence it, but for the smaller players this will make more sense as they are unlikely to be able to afford the huge cost of developing an entire system themselves.
  • This creates an opportunity for those that don’t make cars such as HERE, Mobileye and Google to come up with a neutral offering that can be licenced to anyone that wants it.
  • The auto industry is rightfully wary about Google’s intentions (see here) when it comes to Android Auto but if it is more open with regards to the data it collects, there could even be the possibility for car companies to get its system for free in exchange for some data sharing.
  • Either way, it is likely to be a very long time before autonomous driving achieves the kind of reality that will meaningfully affect people’s lives and the economy.
  • I expect the shake out to begin in 2018 once those developing these systems realise that they will not be able to meet the promises they have made to their backers.

Android Security – Culture vulture

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Security issues highlight more pressing problems. 

  • Google is trying hard to fix the endemic security issues that continue to plague Android devices but unfortunately it is making almost no progress.
  • Since August 2015, Google has been releasing monthly security updates to address the security flaws but there are two big problems.
    • First. Any security patches that Google makes to Android only apply to its own Nexus devices.
    • These devices make up an insignificant proportion of the Android device population meaning that almost no-one receives the updates.
    • Second. The updates themselves have yet to address all of the known security issues in Android.
    • For example, despite monthly updates the mediaserver (finds and indexes media on the device) remains critically flawed.
    • Google is playing a horrible game of whack-a-mole with this component as every time it fixes one flaw, another pops up.
  • I have long believed that Google’s inability to effectively manage Android security and its updates is rooted in its history as a server company.
  • When Google wants to update its search algorithms it simply updates the code on the server and the job is done.
  • Because devices run their own software, they have to be individually updated and it this is very different to the way Google has operated for many years.
  • Consequently, it has taken Google a very long time to come to grips with this problem and I am far from convinced that the issue is close from being resolved.
  • To be effective, all Android devices need to receive these updates which brings in two more big problems.
    • First. Most Android devices are not updatable.
    • Android is a commoditised, brutally competitive market meaning that in the mid-range every cent of cost matters.
    • Making a device updateable means that extra resources have to be added to the device which are never reflected in the price.
    • Consequently, the vast majority of Android devices are not updateable to later versions of Android as there is no incentive for the device maker to add this capability.
    • Second. Google has no control over the update process for any of the devices that run its services.
    • It can update Google Mobile Services (GMS) from Google Play but lower level system updates (Android) are controlled by either the maker of the device or the mobile operator.
  • Consequently, I think that Google has to take control of Android because in its current state, it is very unsecure with no scope for improvement.
  • I continue to believe that this may happen in 2017 as Oracle has provided Google with the perfect excuse to do so (see here).
  • This would result in a series of proprietary ecosystems based on an Android kernel of which GMS, Cyanogen and MIUI would be three.
  • Google still has another good year ahead of it thanks to the underlying growth of Android users, but the medium term urgently requires for this problem to be fixed.
  • I prefer Samsung and Microsoft to Alphabet in the long-term, although the immediate term for Alphabet continues to look good with absolute user numbers still growing very nicely.

Smartphones – The second derivative.

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Gap between ecosystem and hardware to increase this year. 

  • As the slowdown in the smartphone market is more severe than even I had expected, it is Xiaomi that is looking like it is in real trouble.

Smartphone and ecosystem

  • Q1 16A smartphone shipments look they have been flat or declined as much as 3% to around 340m units compared to 344m units in Q1 15A.
  • This is below RFM’s forecast of 1% growth and substantially below that which I believe most commentators and the technology industry were expecting.
  • The problem with the flattening of the market is that handset makers will have to fight even harder to find growth resulting in even greater pricing pressure.
  • This means that in revenue terms the handset market could decline by 5-10% this year.
  • This is great for consumers and for the ecosystem companies that want smartphones in the hands of as many users as possible, but for the hardware makers it is disastrous.
  • All handset makers with the exception of Samsung and Apple are barely breaking even and this added pressure could push more of them into loss making territory.
  • Consequently, I expect that this year will see an acceleration of the shakeout as the smaller companies realise that they have no hope of ever making a decent return by making commodity Android handsets.
  • This further increases my preference for the ecosystem companies as their addressable markets will keep growing despite the stagnation in the handset market.
  • The addressable market for an ecosystem is smartphone users which RFM forecasts will grow by 14% this year to 2.82bn users from 2.46bn at the end of 2015.
  • This is how the likes of Google, Facebook, Baidu, Tencent and so on will be able to post good growth this year despite the hardships being endured by hardware.

Xiaomi

  • The two exceptions to this are Apple and Xiaomi both of which have decided to monetise their ecosystem by selling hardware.
  • However, it is there that the similarity ends as despite its growth issues, Apple is still fantastically profitable.
  • Xiaomi on the hand is not and this is the third quarter in a row where it has lost market share.
  • To add insult to injury it also no longer number 1 in its home market China having been overtaken by both a resurgent Huawei and Oppo.
  • This leads me to believe that Xiaomi has no money to invest in its ecosystem which will in it falling further behind Baidu, Tencent and Alibaba and even China Mobile.
  • For Xiaomi 2015 was a year that it grew, but not as much as it has promised, while 2016 is looking like one where revenues could decline as much as 10%.
  • For a company that last raised money at $46bn on the promise of very rapid growth, this a dreadful outcome as Xiaomi badly needs to invest in its ecosystem, has no money to do so and will have great difficulty in raising any more.
  • To compound its problems it also appears that usage of its ecosystem is waning (see here) which means that the loyalty of its users to its devices may also be in decline.
  • This will further hamper profitability making the outlook for Xiaomi very difficult indeed.
  • I continue to believe that any investor that can offload his shares in Xiaomi at a valuation of $27bn will be doing very well indeed.

Amazon / Baidu Results – Away from home.

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Both companies being driven by new businesses.

Amazon Q1 16A. 

  • Amazon reported mighty results as Amazon Web Services (AWS) grew by 64% YoY and contributed 55% of group EBIT despite only contributing 9% of total sales.
  • Q1 16A revenues / EBIT / EPS were $29.1bn / $1.07bn / $1.07 compared to consensus at $28.0bn / $584 / $0.59.
  • Although North America remained nicely in the black, the star of the show was AWS which generated $604m of EBIT accounting for almost all of the better-than-forecasted performance.
  • This strength also underpinned guidance where Q2 16A revenues / EBIT are forecasted to be $28.0bn – $30.5bn (midpoint $29.25bn) / $375m – $975m (midpoint $675m) compared to consensus at $28.4bn / $878m.
  • Despite being the largest cloud provider, AWS gained share during the quarter and is increasingly looking unassailable.
  • Its huge scale gives it the ability to offer global points of presence which meaningfully improves performance for global companies and it can offer this with lower costs.
  • Furthermore, the underlying AWS software upon which companies build their IT operations is unique to Amazon, making switching an increasingly difficult and painful process.
  • Hence, I think AWS will remain strong which combined with the steady progress in retail keeps the overall growth outlook good.
  • However, the same cannot be said for the valuation.
  • Even including an EPS upgrade to $6.00 for this year and $10.00 for 2017 leaves the company trading on 113x 2016E PER and 68x 2017E which is way too rich for my blood.
  • Amazon’s valuation has been discounting future profits for years and now that they have arrived, it is time for the multiple to begin returning to normal levels.

Baidu Q1 16A. 

  • Baidu reported results that met expectations as profits from its dominant position in search continued to be ploughed into O2O and online video investments.
  • Q1 16A revenues / EPS were RMB15.87bn ($2.4bn) / RMB2.2bn ($340m) almost exactly in line with consensus at RMB15.82 / RMB2.2bn.
  • Mobile now makes up 60% of revenues with Baidu’s ecosystem reaching 663m users meaning that 89.1% of Chinese mobile users are actively using its services.
  • However, this looks like a slight loss of market share as in Q4 15A, RFM estimates that Baidu’s ecosystem reached 89.8% of China’s smartphone users implying that Qihoo and Sohu have gained slightly in Q1 16A.
  • Despite this, search remains hugely profitable but much of this is being ploughed into new businesses
  • This becomes apparent when one separates search from the O2O (online to offline) and online video businesses.
  • Group adjusted operating margins were 15.4% but if losses from O2O and online video are removed, search margins are revealed at 49.8%.
  • Between them, these two businesses have racked up RMB5.7bn in losses in one quarter alone making them a very big bet as far as investors are concerned.
  • Fortunately, the outlook for growth in 2016 is reasonably good meaning that search is likely to keep delivering cash for investment.
  • Whether Baidu can deliver returns on these investments remains to be seen but comments on the call such as “we will worry about the business model later” do not inspire confidence.
  • Baidu has a stranglehold on the Chinese search market very much like Google does in the rest of the world.
  • However, it is there that the similarity ends as Google clearly understands the ecosystem and Baidu does not even though it has reasonably good coverage of the Digital Life Pie.
  • Consequently, everything depends on Baidu being successful with Nuomi, its platform for e-commerce and O2O services.
  • Here its GMV of RMB16bn is just a fraction of Alibaba’s at RMB964bn meaning that it has to do something very special to prevent itself from being squeezed by its much larger and more powerful rival in e-commerce and O2O.
  • Baidu is likely to remain volatile while its develops it services beyond search.

Facebook Q1 16A – Painful splits.

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A stick in the eye for corporate governance.  

  • A great set of results was marred by the timely announcement of a share split that further strengthens the founders’ grip on the company to the detriment of all other owners.
  • Q1 16A revenues / adj-EPS were $5.4bn / $0.77 compared to consensus at $5.3bn / $0.62.
  • Although revenues beat by 2.5%, EPS beat by 23% mostly due to a lower tax rate but also due to expenses growing more slowly than revenues.
  • The outlook for profit and cash flow has also improved as the company stated it should be able to keep expenses within the current plan despite revenues faring better than expected.
  • With 1.65bn MaU’s and 1bn daily users on mobile devices, Facebook still has all the makings of the biggest ecosystem of them all.
  • The good news is that the company has recognised this (see here) and is moving full steam ahead to make the most of the opportunity that it has.
  • The combination of this opportunity and the superb execution of Sheryl Sandberg’s organisation keeps me confident that there is much more to come from this company.
  • However there are few bumps that need to be navigated first.
    • Firstly, I still see problems in the second half of this year.
    • This is because RFM’s research indicates that market expectations in H2 2016 are significantly ahead of what RFM thinks is possible given Facebook’s current level of development.
    • In essence, I think that the market is assuming that revenues will begin to flow from the new strategies before these plans are mature enough to begin generating revenues.
    • The result is likely to be a miss in Q3 16E or Q4 16E that will send the shares into a tail spin.
    • It is at that point that I would be looking to enter for the long term.
    • Secondly, many of Facebook’s new strategies to keep users within its ecosystem require artificial intelligence and machine learning.
    • I think that this is Facebook’s Achilles heel as this is not in the company’s DNA unlike Google.
    • Early interactions with Facebook M and the bots that have been launched (see here) show machines that are far too stupid to be of any real use.
    • If I was a company looking to build a bot to interact with my customers, I would not be using Facebook’s.
    • I would instead be looking at Google or Microsoft as a foundation for my machine intelligence.
    • This is a real problem as unless fixed, it will drive traffic away from Facebook properties and into the arms of its rivals.
    • Traffic is the life blood of Facebook upon which all future revenue growth depends.
  • I am reasonably confident that Facebook has recognised its weaknesses as it has been quick to grasp the importance of the ecosystem concept and so I hope the AI problem will also be fixed.
  • However, the biggest problem is the share split.
  • Just like Alphabet did before it, Facebook is creating a new class of share that has no votes attached to it at all.
  • Two class C shares will be created for every A and B share and will be distributed as a one-time dividend to existing shareholders.
  • This will ensure that the founders’ control of the company will remain unchanged as control and economic interest will become even more divorced than they are today.
  • For small, early stage companies a super voting structure makes sense as speed and decisiveness are needed but I firmly believe that this has no place in large public corporations.
  • I find that the arguments for perpetuating this unfair structure have no merit and I fear that corporate governance has taken a turn for the worse.
  • When this type of structure persists, no one minds until things start to go wrong.
  • When problems arise, founders tend to be more emotionally attached to losing strategies than professional managers.
  • Because no one can force them out or to change, they tend to stick with these losers far longer than they should.
  • The result is that problems tend to be far worse and last much longer than they otherwise would if the shareholders had the power to enact change.
  • The example of Ericsson’s emergency rights issue in 2002 is a great example of how bad things can get with these types of shareholding structures.
  • While Facebook continues to beat expectations no one will care, but from a long term perspective any rational investor should put a discount on his fair value to account for this shortcoming.
  • I place a 30% corporate discount on my estimate for Alphabet, and I see no reason why I should not do the same for Facebook.

Apple / Twitter Results – Show me the money.

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Cash flow is king when growth deserts.

 Apple FQ3 16A. 

  • Apple reported difficult FQ2 results but critically, iPhone shipments fell by far less than many had feared, confirming my view that this is the end of a cycle not a secular decline.
  • FQ2 16A revenues and EPS were $50.6bn / $1.90 missing consensus of $52.0bn / $2.00.
  • iPhone shipments were 51.2m compared to consensus of 51.0m with ASPs of $642 compared to $670 in FQ1 16A.
  • A large part of the ASP weakness can be attributed to the strength of the USD which impacted overall revenues by 4% during the quarter.
  • iPad shipments were 10.3m slightly better than expected driven by the larger screen iPad Pro.
  • Mac shipments were 4m slightly missing expectations as the weakness in the PC market has finally impacted demand for Macs.
  • Guidance was also disappointing with FQ3 16E revenues and gross margins expected at $41bn – $43bn / 37.5%-38.0% missing consensus at $47.6bn / 39.2%.
  • Apple explained the shortfall as a $2bn inventory adjustment to reflect a more cautious outlook, the impact of the lower iPhone SE ASPs and the weaker outlook for the PC market.
  • However, I continue to believe that the issue that Apple faces is simply that the iPhone 6 product cycle has come to an end.
  • The iPhone 6 addressed a new segment of the market for the first time and also addressed the biggest complaint of iPhone owners namely the small screen.
  • Consequently, there was a lot of pent up demand for the device and many users also switched from Android to iOS.
  • This phenomenon is now over and iPhone demand has normalised leaving Apple looking at declines in revenues while its performance is being compared to periods when the cycle was in full swing.
  • What concerns me more is gross margins which will suffer in the coming quarter from the lower revenue base and a weaker product mix.
  • I highlight gross margins as they are the precursor to cash flow, and with a company that is not growing, cash flow is of paramount importance.
  • Apple has $232bn of gross cash meaning that the enterprise value of the company is $372bn (taking into account after hours trading and $70bn of debt).
  • This quarter Apple generated free cash flow of $33bn which taking into account the lower guidance, the slowing market and capex should comfortably come in at $120bn over the next 12 months.
  • This is a free cash flow yield of 32% to anyone holding the equity today and Apple is clearly moving to return more cash to shareholders.
  • With this level of return, I think growth is irrelevant but profitability must remain very strong for this thesis to work.
  • I see no real immediate threat to Apple’s profitability and on the basis of cash flow yield, the shares are extremely attractive.

Twitter Q1 16A. 

  • Twitter reported bad results as the fundamentals of the company performed more in line with RFM forecasts than the overly optimistic market.
  • Q1 16A revenues / adj-EPS were $595m / $0.15 compared to consensus at $608 / $0.10 and RFM at $573m.
  • User numbers managed to pick up a little coming in at 310m compared to consensus at 308m but guidance was very weak.
  • Q2 16E revenues are expected to be $590m-$610m compared to consensus at $678m and RFM at $576m.
  • The culprit was lower demand than expected from branded advertisers, underlining my long held concern that advertisers do not want to spend more on Twitter because its focus remains too narrow.
  • Twitter only covers 17% of the Digital Life Pie meaning that users spend the vast majority of their time on devices doing something that is outside of services that Twitter offers.
  • This fundamentally limits Twitter’s attraction to advertisers which combined with its flat-lining user growth is why revenues are grinding to a halt.
  • To turn this around, Twitter needs to find something to encourage to users to spend more time within its properties and break out of being a news broadcaster.
  • If successfully executed, I think this would have the effect of restarting user growth and reigniting advertiser interest which would unlock a period of very rapid, catch-up growth.
  • Unfortunately, this requires focused and highly engaged management team which I believe is impossible with a part time CEO.
  • Until this is rectified, I think the company will languish with very little or no growth.
  • Twitter does not have fantastic cash flow to support its valuation.
  • In the last 3 months generated a fairly meagre $103m in free cash flow translating into a yield of just 1% compared to Apple at 32%.
  • This why I think Twitter could test $10 per share as the reality of its lack of growth sinks in there is no real cash flow to backstop the valuation of the equity.

Apple Auto – Titanic task

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Like the television, I think the car will never launch.  

  • While I am sure that Apple is engaged in building an autonomous automobile, I think that it is finding it much harder than expected and I still do not expect it to ever launch.
  • I think that this is similar to the large screen television that Apple built but never launched albeit on a larger scale.
  • The issues I have with Apple becoming a car maker are simply that making these sorts of products is not something that Apple really knows anything about nor is the market or regulation of cars like anything else in which Apple is currently active.
  • This is why I think Apple turned to BMW and Daimler for their experience and expertise in building these sorts of high quality products.
  • However, both of these companies have realised how important the data the vehicle generates is and consequently refused to allow Apple to store it in iCloud.
  • The net result appears to be that Apple has turned instead to one of the tier 1 suppliers as these companies are much less likely to have these sorts of objections.
  • Apple partnering with a member of the automotive industry does not alleviate the most pressing problem with Apple selling a car which I think remains profitability.
  • Apple prides itself on earning 40% gross margins on the products that it sells and unless it can earn 40% gross margins on wheels, brakes and sheet metal, an automobile will be significantly margin dilutive.
  • I think that this would be catastrophic for the valuation of the company as a main pillar of Apple’s valuation is its fantastic profitability.
  • Many car companies make no money at all on the products that they sell but instead earn a return on the financing that they provide to make it easier for consumers to buy their products.
  • Against this backdrop, 40% gross margins on a car, even one with an Apple badge on it, look hopelessly unobtainable.
  • It is clear that the automobile will become an important device in the digital ecosystem where users live their digital lives making it an area that Apple cannot ignore.
  • Consequently, Apple needs to understand the automobile industry and its users and the best way to do that is to get one’s hands dirty and build one.
  • From an economic standpoint, it still makes most sense for Apple to make an infotainment unit (see here) but all of the car makers have realised the strategic importance of the infotainment unit to their brands long term.
  • Hence, none of them are about to leave a hole in the console for Apple to fit its unit, earn 40% gross margins and suck out all of their data.
  • As a result, I think that Apple’s future in the automotive market is very uncertain as both avenues of earning a return through selling hardware look like dead ends.
  • I think that project Titan is designed to teach Apple what it needs to know about the automotive industry so that it is in a position to make the most of whatever opportunity appears in the future.
  • This could be services, a companion device, an autonomous driving system or even a partnership but I still think it extremely unlikely that there will ever be an iCar.
  • Apple remains very lowly valued but its lack of growth is likely to hamper appreciation in the share price.
  • Apple looks good for long term holders but those looking for share price appreciation in 2016 would do better to look at Microsoft or Samsung.

Amazon – Proper practitioner?

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Signs of progress at last.

  • Amazon is finally showing some early signs that it is beginning to understand the value that creating an ecosystem could bring to its bottom line.
  • Amazon’s has made some changes to its Amazon Prime as well as to its Twitch website which point to expanding coverage of Digital Life as well as understanding the importance of user numbers.
  • These changes are:
    • First. Amazon has added some new service levels to Amazon Prime.
    • In addition to the $99 per year tariff, there is now a $10.99 monthly that can be cancelled with one month’s notice and an $8.99 video only tariff.
    • This brings Amazon more into line with Netflix and Hulu but I hope that there is more to this tariff than just meeting these two.
    • Second. Amazon’s gaming video website, Twitch, is moving away from being just a place to upload video like YouTube and becoming more like a social network.
    • Twitch already had the facility for private messaging but with its new friend function, it is beginning to look more like Facebook than YouTube.
  • These changes could start to meaningfully improve the appeal of Amazon to users who are not hard-core gamers or shoppers but there is still a very long way to go.
  • To date RFM has been of the opinion that Amazon has not had any real understanding of the ecosystem as it was making no real effort to make its ecosystem larger.
  • RFM research indicates that 100m users are needed for an ecosystem to hit critical mass but 300m are needed for real money to be made.
  • I think that any ecosystem that Amazon creates will be based upon Amazon Prime and to date, I believe that the requirement to take the free shipping option has been a hindrance to take-up.
  • Consequently, Amazon still has less than 50m users which I think needs to be massively expanded for Amazon to make the most of the digital assets that it has assembled.
  • A lower price point to enter the ecosystem is required as well as greater coverage of Digital Life and much greater cohesion between the assets and services that it owns.
  • The new Amazon Prime tariff is a step in the right direction but it needs to become even cheaper, or even free, for Amazon to really see the take up it needs.
  • I not about to forecast that Amazon will now become a thriving and vibrant ecosystem but importantly there are now signs that Amazon has understood what is required and that more changes and upgrades are to come.
  • I would also like to see Amazon integrate all of its properties together such that it can really understand its users as well as offer a more seamless and delightful user experience.
  • That combined with a much lower barrier to entry is what will drive user uptake and turn Amazon from a dabbler into a proper practitioner.
  • I continue to struggle with Amazon’s valuation as owners are already paying for profits which are not being made.
  • Consequently, I still prefer Samsung, Microsoft, Apple or even Alphabet compared to Amazon.

MSFT Q3 & GOOG Q1 – Two more strikes.

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Microsoft and Alphabet compound Ericsson’s and Intel’s woes

Microsoft FYQ3 16A

  • Microsoft reported reasonable results as the weakness in the PC market did not hurt the company as much as Intel’s troubles lead me to fear.
  • FYQ3 16A revenues / adj-EPS were $22.1bn / $0.62 compared to consensus at $22.1bn / $0.64 and RFM at $20.3bn / $0.52.
  • The continued shift towards cloud based businesses is putting some pressure on gross margin but also increasing the tax rate which was largely responsible for the EPS miss reported.
  • Growth has continued in all of the really important areas (cloud and Office 365) and Microsoft has done well to mitigate the impact of weakness in the PC market.
  • Phones continued their tail-spin leaving the question with regards to what Microsoft will do with its consumer ecosystem wide open. (see here).
  • Guidance for FYQ4 was also a little soft with revenues forecast at $21.7bn – $22.4bn compared to consensus at $23.1bn (4.5% miss) and RFM at $21.9bn.
  • PC weakness and very slight softness in the cloud is being blamed for the small undershoot, but frankly I don’t put too much weight on single quarters.
  • The net result is a small reset in expectations that in reality does not change the long term outlook.
  • Here Microsoft remains a dominant force in Digital Work and that alone is enough to justify holding the shares.
  • The free option that is the consumer ecosystem remains a huge question mark which I hope will soon be addressed.
  • I still see value in Microsoft and with the market selling off to the low $50’s, it just became more interesting.

Alphabet Q1 16A

  • Google reported weaker than expected results as traffic from sites and devices not under its control grew faster than its owned properties.
  • Q1 16A revenues-Ex TAC / adj-EPS were $16.47bn / $7.50 compared to consensus at $16.56bn / $7.96 and RFM at $16.12bn / $7.69.
  • Alphabet explained away this weakness by stating that profits had suffered as a result of mobile’s growth and the higher Traffic Acquisition Costs (TAC) that are associated with it.
  • I think that this is not a very good explanation as growth in mobile has been going on for some considerable time and this has never been a problem before.
  • Hence, I suspect that the reality here is that the last few quarters have been driven by the increase in market share of iOS where Google generates far higher revenues than it does on Android.
  • The end of the iPhone 6 product cycle means that Android devices are once again growing their share in the Google ecosystem and here I think that Google has lower gross margins.
  • I think that these lower gross margins are driven by the costs of developing and maintaining the Android OS as well as the nature of the revenue sharing agreements compared to its deal with Apple.
  • These agreements often have a cap and it is likely that the iOS cap has already been surpassed.
  • This combined with the slowing outlook for mobile devices and ecosystem user growth in general means that the Google business will slow in the medium term.
  • This is something that is not unexpected but for a market that struggles to see past the next three months, it is comes as a surprise.
  • In light of the slower outlook, Google is taking action and I see the rationalisation of its investments in Other Bets as well as the fact that G&A expenses fell to 7.5% of sales in Q1 16A as a good sign for fiscal discipline.
  • Alphabet is becoming a mature company which combined with its recent rally makes me pretty indifferent to the shares.
  • I am also indifferent to Apple but there are far fewer risks to the outlook at this time making this a better place to hide.