Apple Q2 15A– The mighty cycle

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iPhone replacement drives big Q2 15A results.

  • Apple reported excellent Q2 15A results as the iPhone replacement cycle has remained strong.
  • Apple increased its cash return program by more than 50% to $200bn.
  • Q2 15A Revenues / EPS of $58.0bn / $2.33 comfortably beating consensus at $55.7bn / $2.13 despite the currency headwind that crimped the results of all its peers.
  • 61.2m iPhones shipped compared to consensus at 58m, 4.6m Macs shipped compared to consensus at 4.7m and 12.6m iPads shipped compared to consensus of 13m.
  • Once again the iPhone carried the day and more than offset the small miss in Macs and the ongoing weakness in iPads.
  • This underpinned gross margins which came it at 40.8% nicely above the guided range of 38.5%-39.5%
  • This allowed another $15.6bn of cash to be added to the pile, bringing it to $193.5bn.
  • The problem is that 88% of the cash is held overseas and is unavailable for dividends or buybacks without paying the hefty repatriation tax of around 30% when bringing it back into the US.
  • Guidance for Q3 15E was in line with forecasts with revenues / gross margin of $46bn-$48bn / 38.5%-39.5% expected compared to consensus of $47bn / 38.9%.
  • Apple remains in the grip of a very strong replacement cycle which I suspect could continue until calendar Q3 15E.
  • The larger screen has allowed Apple to address the single biggest shortcoming of owning previous devices.
  • This combined with a nice design, superb radio and good enough battery life has encouraged existing iPhone users to upgrade sooner than they normally would as well as meaningful switching from Android.
  • It popularity is also allowing Apple to hold pricing steady meaning that it continues to monetise ecosystem extremely effectively.
  • Although Apple does not really have Digital Life services of its own, it distributes third party apps in an easy and fun to use way that remains unrivalled.
  • The other ecosystems are catching up but still have a long way to go giving me confidence that Apple has time to plot its next move before the iPhone becomes commoditised.
  • That being said, this is all pretty much in the share price of Apple already leaving me preferring the ecosystems with more growth (Google) or those mounting a credible challenge (Microsoft).

 

Amazon Q1 15A– Silver lining

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Amazon Web Services outshines a dull earnings report

  • Amazon Web Services (AWS) was the bright spot in a set of results that came pretty much in line with expectations.
  • Revenues / EPS were $22.74bn / LOSS $0.12 compared to forecasts of $22.4bn / LOSS $0.11.
  • Guidance was weak with revenues / EBIT expected at $20.6bn-$22.8bn ($21.7bn) / LOSS $500m – $50m (LOSS $225m) compared to estimates of $22.1bn / LOSS $15m.
  • However, Amazon revealed that its Cloud business, Amazon Web Services (AWS) is much bigger and more profitable than many had expected.
  • In Q1 15A AWS grew revenues 49% YoY to $1.6bn and reported operating margins of 16.9% which is far ahead of what most commentators had assumed.
  • By contrast Microsoft’s Azure business is currently at $1.1bn in sales but is growing at 114% and I estimate that gross margins are around 40%.
  • I think that most commentators had assumed that AWS was roughly the same size as Azure and very unprofitable.
  • This surprise has caused many to meaningfully increase their valuations of this part of Amazon.
  • This report shows that Amazon is comfortably the leader in the public cloud but it also shows that outside of AWS nothing else has changed.
  • Amazon is still investing heavily in growing its empire but there is no sign that these investments are being made with any particular strategy in mind.
  • Instead they continue to feel like a random series of experiments with Amazon throwing mud at the wall to see what sticks.
  • Unfortunately, nothing is sticking and this is because Amazon still seems to have no real understanding of the ecosystem.
  • It has a range of assets such as Amazon Prime, Kindle, Twitch, Maps and so on but all of them are independent from one another.
  • In order to be a coherent, easy to use and fun ecosystem, Amazon needs to integrate these offerings together into something where users are going to want to spend their Digital Lives.
  • Furthermore, Amazon needs to split its free shipping off from its ecosystem as this creates a $99 per year barrier to joining the ecosystem.
  • To me the fact that it has not done this is evidence that still has no understanding of it is trying to achieve and until it does it is likely to continue wasting money on experiments that yield no results.
  • Amazon remains very far from the top of my list of places to be in the digital mobile ecosystem.

Microsoft & Google– 2 for 2

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Strong US$ masks good fundamental developments.

  • Microsoft and Google produced good results that were marred by the problems caused by the strong US$.
  • Both saw good developments in the core businesses, justifying their position as my top choices in the digital mobile ecosystem.

Microsoft

  • Microsoft reported strong numbers as adoption of its cloud offering and Office 365 continued to outpace expectations.
  • Q31 15A revenues / adj-EPS were $21.7bn / $0.64 compared to consensus at $21.1bn / $0.53.
  • Although the PC market has continued to be weak during the quarter, growth in Office 365 users and enterprise adoption of Azure has more than offset that weakness.
  • Furthermore, revenues from Windows being sold to corporates has stabilised after the bump caused by the end of support of Windows XP.
  • This is good news as with this revenue stream stable, Microsoft can concentrate on delivering growth from its new businesses.
  • Unfortunately there are danger signs when it comes to smartphones.
  • With 8.6m units shipped during Q1, RFM estimates that Microsoft has lost share again to just 2.6% globally.
  • Some of this is due to its tighter geographic focus when compared to its peers, but Microsoft cannot afford to continue losing share.
  • RFM research indicates that the smartphone is at the heart of the ecosystem and it is upon this device that most users make their choice.
  • Whatever the circumstances, the problem is that falling market share damages the credibility of the platform and will dissuade third parties from supporting it and consumers from buying it.
  • Financially, this is an insignificant blot on a good set of results from Microsoft, but without a credible smartphone platform, winning users over to its ecosystem will much more difficult than it already is.

Google

  • Google reported a fair set of Q1 15A results as revenues were just shy of expectations but stripping out the FX effect reveals a strong underlying performance.
  • Q1 15A revenues-exTAC / EPS were $12.9bn / $6.57 compared to estimates of $14.0bn / $6.63.
  • During Q1 15A Google suffered as many of its peers have suffered from the strong US$ which it estimates held back revenues by about 5%.
  • Without the impact of the US$ growth would have been 17% which would have put both revenues and profits nicely ahead of expectations.
  • Mobile continued to be the engine of growth where RFM sees most of the growth coming from Android devices.
  • The market was expecting a harder hit from the strong US$ which combined with some progress on OPEX was met with a relief rally.
  • Google has been more efficient on its marketing spend but at 8.1% of revenues its General and Administrative expenses remain way too high.
  • That combined with the poor corporate governance continue to spoil what it is an excellent story.
  • Fortunately, investors continue to be well compensated for these shortcomings and I still see some upside in Google in the medium term.

Facebook & Sony– Irrelevant variance

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Variances from expectations have little to do with fundamentals.

  • Facebook reported results and Sony pre-announced results that differed from expectations but neither were very relevant to the underlying story of either company.

Facebook

  • Facebook reported Q1 15A results that were weaker than expected but this looks to have been almost entirely due to the strong US$.
  • Revenues / EPS were $3.54bn / $0.42 compared to consensus at $3.56bn / $0.40.
  • Advertising revenues were 72% derived from mobile and grew by 46% YoY to $3.32bn.
  • Given that Facebook is now a global company, a substantial portion of its revenues are no longer in US$ and the 6% strengthening of the US$ during Q1 15A did some damage.
  • Removing the effect of the US$, advertising revenues would have grown by 55% rather than 46% which more than accounts for the weakness seen on the top line when compared to consensus.
  • The impact of currency is expected to be greater in Q2 but Facebook has brought down its OPEX growth estimate slightly from 55%-70% for 2015E to 55%-65%.
  • The net result is a set of figures that were hurt by currency but the fundamentals remained strong.
  • Facebook still needs to cover more of Digital Life in order to secure long term growth but its excellent execution when it comes to mobile is buying it time to get its house in order.

Sony

  • Sony effectively preannounced its fiscal 2015A (ended March) results (Due April 30th) by updating its guidance.
  • Revenues will now be JPY8,210bn compared to its previous estimate of JPY8,000bn (+2.6%) given in February and EBIT will now be JPY68bn compared to the previous guidance of JPY20bn.
  • Although this represents a tripling of the operating profit forecast, profitability is currently still very low meaning that a little change goes a long way.
  • The main reason for the upgrade in revenues is due to Financial Services, Imaging Products and Game and Network.
  • Given that the strength in Imaging products and Game and Network is already fairly well known (see here), I suspect this upgrade is almost all due to Financial Services.
  • Furthermore the improvement in profitability is almost all due to a write back of provisions taken at the Sony Life Insurance division due to good performance of its securities portfolio.
  • Consequently, this pre-announcement has very little do to with the key issues that Sony needs to address to return itself to profitable growth.
  • All eyes will be focused on the FY16E guidance given on April 30th but the bigger issue remains the developments of its ecosystem.
  • I expect Sony to continue with its strategy of developing its own ecosystem and hope these improving results will give doubters in the company a little more faith that it can be done.
  • Sony remains the only Japanese company that I think has a real potential to have a future in consumer electronics although it will be a long hard road.

Yahoo! Q1 15A– The last rabbit

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Yahoo! Japan will be the last rabbit to distract the market.

  • Yahoo! pulled its last rabbit out of the hat and in doing so successfully diverted the market’s attention from another disappointing set of results.
  • Q1 15A revenues-ex TAC / adjusted EPS were $1.04bn / $0.15 missing consensus of $1.06bn / $0.18.
  • The headline figures which are gross revenues before the deduction of traffic acquisition costs showed some improvement but this appears to be almost entirely due to the deal that has been signed with Mozilla.
  • Yahoo! is now the default search provider for Firefox and the first effects of that were seen during Q1 15A.
  • Mozilla clearly struck a good deal with Yahoo! as headline revenue growth of 8% became a decline of 4% YoY once TAC had been deducted.
  • Mobile, Video, Native and Social (Mavens) which make up the growth part of Yahoo! saw 58% revenue growth to $363m but are still not big enough to offset the poor performance of the underlying business.
  • Yahoo! made much of generating $234m in revenues from 600m mobile users, but I would argue that this is underperformance on a grand scale.
  • RFM estimates that in Q1 15 Google generated $2.3bn in revenue from its 684m Google ecosystem users on Android.
  • Yahoo! actually has better coverage of Digital Life than Google does (Google is missing gaming) and hence the opportunity for it to generate revenues on mobile is actually greater than Google’s.
  • If its claim to have 600m mobile users is accurate and its house was in order, it should have generated $1.98bn in revenues in Q1 15A using Google as a benchmark.
  • The missed opportunity of $1.75bn is due to the company’s failure to develop its acquisitions into an ecosystem of integrated Digital Life services that are easy and fun to use.
  • On this front there has been no progress and until Yahoo! executes on creating its mobile ecosystem, it is likely to continue vastly underperforming its potential.
  • This fact was evident in Q2 15E guidance where revenues are expected to be $1.01bn-$1.05bn below consensus of $1.054bn.
  • Yahoo! attempted to cover up this failing by announcing that it is now exploring strategic opportunities for Yahoo! Japan.
  • After this has been sold and the proceeds returned to investors, the hutch will be empty of rabbits with which to distract investors from the underperformance of the core business.
  • A quick glance at its competitors Google, Facebook, Twitter and so on show just how badly Yahoo! is underperforming when it comes to exploiting the opportunity it has before it.
  • Until Yahoo! begins to execute on its vision rather than just accumulating assets nothing is going to change.
  • Of this there is no sign and I see no reason to go near Yahoo! for some time to come.

Samsung, QCOM & TSMC – Win Win Lose

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Qualcomm and Samsung get one over TSMC.

  • Despite losing out to Samsung’s in house Exynos apps processor in the Galaxy s6, Qualcomm looks to be back on track for the flagship device in 2016E.
  • There were problems with the Snapdragon 810.
    • Firstly, in Samsung’s hands it caused its device to overheat.
    • I suspect that this actually had little to do with Qualcomm (see here), but it was an issue when it came to adoption of the 810.
    • Secondly, the Snapdragon uses a standard ARM designed processor rather than Qualcomm’s own design using ARM’s IP.
    • Qualcomm has long used its own designs in its chips and has been able to achieve better performance as a result.
  • Consequently, the Snapdragon 810 just did not work well for Samsung prompting it to use its in house processor.
  • However, the Exynos has no on board modem meaning that another modem chip is required which increases costs.
  • At the same time, Samsung has ramped up its 14nm production capacity and it looks like Qualcomm will be using that for the Snapdragon 820 rather than TSMC.
  • Qualcomm has typically used TSMC for its leading edge chips due to its superb execution capability at the leading edge.
  • This has three benefits for both Qualcomm and Samsung.
    • First. This will make the hurdle much lower for Samsung to use the Snapdragon 820 in its next flagship product.
    • This is because the total cost to Samsung Electronics of using Qualcomm will be meaningfully lower.
    • Instead of 49% gross margin accruing to TSMC, that margin will stay inside Samsung, significantly reducing the overall cost of using Qualcomm compared to its in house chip.
    • Second. Samsung will no longer have to use a companion modem as the 820 has the modem on board which will reduce costs further.
    • Third. As the Snapdragon 820 will use Qualcomm’s own processor design, the performance should be better.
  • This will also help Qualcomm’s gross margin as Samsung LSI is in ramp up phase and is still prepared to accept lower gross margin in order to gain share compared to TSMC which is holding steady at 49%.
  • The real loser here is TSMC.
  • Samsung has managed to get a technical edge over TSMC by going to 14nm early, which combined with keeping more revenues in house, can reap greater benefits by using Qualcomm than before.
  • Despite this benefit, I still see Samsung struggling to return to its former glory in handsets and am nervous that management has set market expectations too high.
  • I would prefer Microsoft or Google for exposure to the digital mobile ecosystem.

 

 

Xiaomi – Hardware heaven?

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Right strategy but where is the money?

  • Xiaomi has exactly the right strategy to develop a thriving ecosystem of its own but whether it can make money from it is another thing entirely.
  • There are three ways to monetise an ecosystem: selling hardware, selling advertising or selling subscriptions to one’s Digital Life services.
  • Xiaomi has chosen the hardware route and seems to be developing that by investing in many different device companies.
  • RFM research indicates that hardware is by far the best monetisation mechanism but it is also the riskiest.
  • Not only is organic growth in hardware grinding to a halt, but if one misjudges a product cycle, market share and margins can collapse in a matter of months.
  • RFM research has also identified that offering an ecosystem consistently across a range of devices is becoming an important factor when it comes to having a successful ecosystem.
  • Most ecosystem contenders and hardware makers have approached this problem by making all of the devices themselves, but Xiaomi’s approach is very different.
  • Xiaomi does this by investing in a range of start-ups whose products should then become part of the Xiaomi ecosystem.
  • So far Xiaomi has invested in around 20 start-ups but it plans to invest in a hundred more.
  • The latest addition to the family is Segway which has just been acquired by one of its hardware partners Ninebot.
  • Assuming that 4/5 start-ups never amount to anything, this would leave Xiaomi with around 20 different device types within its ecosystem with Xiaomi phones at the centre.
  • Assuming that Xiaomi’s ecosystem drives device preference, then these devices should all be able to command a price premium over competition, allowing them to generate higher margins.
  • However, Xiaomi will only be a minority owner in these companies meaning that it will not reap the full benefit from the ecosystem that it has created.
  • I suspect that there will be a revenue or profit share payable back to Xiaomi as the creator of the ecosystem which will help, but this will not take it into Apple’s league when it comes to revenue and profit generation.
  • However, other devices could be a meaningful factor in driving device preference for Xiaomi smartphones which would help it to increase pricing and earn a better return on its own smartphones.
  • Unfortunately, all of this is predicated on developing a thriving ecosystem.
  • Xiaomi is off to an excellent start with its media consumption offering and its app store.
  • However, it still only has 17% of Digital Life covered meaning that it has an awful lot more services to develop.
  • Furthermore, in its home market it is up against Baidu, Tencent, Alibaba and China Mobile all of whom have big ecosystem ambitions of their own as well as much greater resources.
  • Xiaomi has the first mover advantage but will have to invest heavily to stay ahead of its competitors meaning that margins are likely to stay low for some time to come.
  • Xiaomi has by far the greatest understanding of what is required to create a thriving ecosystem, but it is still uncertain whether it will be able to fully monetise it.
  • This is why when valuations of $45bn or even $100bn get waved around, I get concerned that an awful lot of success is already being priced into the equity of the company.
  • I would prefer to consider Lenovo’s potential IPO of its mobility division which may come at a fraction of the valuation despite its higher global market share and greater scale.

Yahoo! – Nowhere to go

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Yahoo! had little choice but to stay with Microsoft.

  • The changes that have been made to the search contract between Microsoft and Yahoo! are cosmetic and reveal how Marissa Mayer is still failing to breathe any real life into Yahoo!.
  • Microsoft and Yahoo! have extended their search agreement made in 2009 where Microsoft will power Yahoo!’s desktop search and pay Yahoo! a percentage of the advertising revenue as TAC (Traffic Acquisition Cost).
  • There are two changes:
    • First. The relationship is no longer exclusive meaning that Yahoo! can use other search providers (including its own).
    • Second. Sales teams have split responsibility along the fault lines with Microsoft dealing with all ads delivered by Bing and Yahoo! for its own Gemini advertising platform.
  • While this reads like an improvement in the terms for Yahoo!, in practice very little is likely to change.
  • Search is now effectively a one horse race with one challenger struggling along in distant second place.
  • Yahoo! effectively has nowhere else to go and whatever in house development it has attempted is clearly not good enough to replace Bing.
  • It was only a few quarters ago when it was widely thought that Marissa wanted to exit entirely from the deal with Microsoft and go it alone.
  • Clearly at the time she felt strong enough to do that but much has changed in the last 18 months.
  • Yahoo!’s revenues have continued to flounder despite $1.2bn of revenues in 2014A coming from mobile.
  • Furthermore, analysis of these figures in combination with Yahoo!’s assets shows that it underperformed its revenue potential in mobile by $4.4bn in 2014A (see here).
  • This combined with a lack of execution on integrating and improving its ecosystem and moving it into mobile, leaves Yahoo! in a weak position when it comes to negotiation.
  • This is why I suspect Yahoo! has agreed to renew this contract despite a clear desire to go it alone and it does not bode well for the future.
  • Yahoo! will report Q1 15E earnings on 21st April 2015 and I do not expect it to be a happy event.
  • I think that revenues have continued to drift sideways highlighting the underperformance of Yahoo! against its peers like Google, Facebook, and Twitter among others.
  • Yahoo!’s problems can be summed up in one word: execution.
  • The acquisition strategy has been excellent as Yahoo! has gathered a good offering of Digital Life services from which it can build a thriving ecosystem.
  • Furthermore it has a strong user base and high usage in the fixed internet upon which to build.
  • Unfortunately, acquisition is where the story has stopped as nothing seems to have been done with regard to putting them all together into a coherent, easy to use and fun way on mobile.
  • This is the single biggest challenge facing Yahoo! and until it begins to execute on this, its numbers will continue to drift sideways or downwards.
  • Yahoo! will dress up the story in many ways but the numbers speak for themselves.
  • Microsoft is a challenger that is far more likely to succeed and Google is the only way to be exposed to the Android ecosystem.

 

Netflix Q1 15A – The balance of power

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Everything depends on Netflix achieving scale.

  • Netflix reported Q1 15A results slightly below expectations but the subscriber growth was better than forecast and this continues to be the main driver of the shares.
  • Q1 15A revenues / EBIT were $1.57bn / $97.5m compared to consensus at $1.57 / $106m but all the attention was on the subscriber count.
  • Netflix added 2.28m subscribers in the US and 2.60m elsewhere to bring the total to 62.27m of which 59.62m (96%) are paying subscribers.
  • Total net additions of 4.88m subscribers in Q1 15A was ahead of company guidance of 4.1m which has been attributed to NetFlix’s increasing stable of exclusive shows headlined by House of Cards.
  • The company is starting to see some benefits of scale as gross margins in the US improved to 31.7% ahead of company guidance at 30.1%.
  • International, with its much smaller user base continued to see negative gross margins.
  • Guidance was pretty cautious with 2.5m net additions expected and revenues / EBIT of $1.47bn / $59 compared to consensus of $1.66bn / $132m.
  • This did nothing to halt the unbridled optimism based on the user numbers that sent the shares up 12% in after-hours trading.
  • As Netflix grows its user base and relies more heavily on its own, exclusive content, three main dynamics driving the business model emerge.
    • First. Netflix is becoming similar to a software company.
    • Netflix incurs low additional costs to deliver its exclusive content to additional users.
    • This means that if the company can continue to increase its user base then substantial improvements in gross margins are probable.
    • They are never going to reach the 90% that Microsoft can earn as the cost of delivering the content is a meaningful factor, but they should be able to reach levels far above where they are today.
    • Second. Netflix is becoming a data company.
    • A significant percentage of the domestic market are using its service and critically it knows far more about its users than the cable or satellite companies do.
    • This data gives Netflix the ability to suggest and curate content that it knows that its users will like based on their viewing habits.
    • This will mean it knows exactly to whom to market its new and existing shows making marketing much easier and much more efficient.
    • Netflix currently spends 12.3% of revenues on marketing which I think could be meaningfully brought down over time.
    • This data could also be used for advertising and a free tier of service but given almost everyone pays for the service today, this is unlikely to happen any time soon.
    • Third. If subscribers continue to grow, then the balance of power will begin to shift in its favour.
    • Content creators will increasingly realise that they have to have their content on Netflix to reach the mass market giving Netflix much more power when it comes to content rights negotiations.
  • All of these factors should have a positive impact on gross margin and OPEX over the long term but are completely dependent on Netflix’s ability to reach critical mass.
  • RFM’s ecosystem research strongly suggests that this critical mass will start to really factor in gross margin when the company passes 100m subscribers.
  • Netflix is now trading on 162x and 108x 2015E and 2016E PER and 4.8x and 3.9x 2015E and 2016E EV/Sales indicating that much of this margin story has already been priced in.
  • The revenue and critical mass element has clearly not been priced in, and this could be a source of upside if it becomes clear that Netflix will pass 100m subscribers.

Intel Q1 15A – Data centric

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Data centres rescue the quarter but not the year.

  • Intel reported Q1 15A results in line with reduced expectations but guided well thanks to the continued strength of the data centre.
  • Q1 15A revenues / EPS were $12.8bn / $0.41 which was exactly in line with consensus given the profit warning given earlier in the quarter.
  • As usual, the problem was the PC market but in this instance it was not the consumer but the small and mid-size businesses that bought fewer PCs than expected.
  • Last year, the ending of support by Microsoft for Windows XP drove many business to upgrade their PCs to Windows 7.
  • This trend drove the PC market to recover slightly in 2014A but the trend has ended more quickly than expected.
  • To keep the momentum going a pick-up in the laptop replacement cycle was needed which is something that I think can only be driven by tablet PCs. (see here).
  • Without this pick-up in the laptop replacement cycle, the result is a weaker than expected market.
  • I expect that this scenario will persist until users begin to understand how much better the use case for a tablet PC is over a laptop and make the switch.
  • Unfortunately, these advantages are not obvious and until Intel and Microsoft get their act together and start explaining the proposition, users are unlikely to bite.
  • The good news is the data centre where demand has been stronger than expected allowing Intel to guide better than feared.
  • Q2 15E revenues will be $12.7bn – $13.7bn ($13.2bn) which is slightly behind consensus of $13.5bn but clearly the market was braced for much worse following the profit warning in Q1 15A.
  • Intel also moved to account for weaker expectations overall for the PC market in 2015E by reducing its full year revenue forecast from mid-single digit revenue growth to approximately flat.
  • This puts an end to any hopes of revenue growth and moves Intel into line with RFM forecasts which is forecasting a decline of 1.3% to 311.8m units in 2015E.
  • Profitability remained strong as the mix shift towards the data centre is helping gross margins remain in the low 60s.
  • That being said, Intel is taking a more cautious stance to 2015E and is trimming capex and share buy backs to reflect its expectation that cash flow will be lower than originally budgeted.
  • Intel’s mobile business is on track to lose $3.2bn this year which is $800m less than last year but represents a huge investment.
  • Intel is effectively paying companies to make devices that use its chips and still none of these have gained any real traction in the market.
  • With every quarter that passes, Intel’s challenge to ARM in the mobile market weakens and throwing good money after bad is not helping.
  • Consequently, I do not see Intel mounting a credible challenge to ARM in the mobile market but at the same time ARM’s forays into PCs and servers have also not been successful.
  • Intel and Microsoft would be my top choices for ways to play a recovery in the PC market but for another year it looks like my hopes will be dashed.
  • In the long term, Microsoft and Google remain the best ways to play the digital ecosystem.