Cyanogen – Share of zero

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The best option is to sell itself to China. 

  • There are further signs that Cyanogen is in trouble as it is laying off staff and may be about to go through yet another change in strategy.
  • This is a far cry from 12 months ago when it had $80m in the bank and was planning on reaching at least 200 people by the end of 2016.
  • Unfortunately, its business model of revenue sharing with Digital Life service providers enabled through its software, has never made any sense and now I see Cyanogen is adjusting to that reality.
  • The example of Microsoft serves as an excellent example of how this strategy was never going to work.
  • Cyanogen announced with great fanfare in April 2016 that it would be integrating Microsoft Office and other services into Cyanogen upon which it would presumably collect a revenue share.
  • Unfortunately, all of Cyanogen’s devices have screens of less than 10” and on these devices, Office is free.
  • Consequently, while a partnership with Microsoft is great for the headlines, it never really had any chance of generating any revenues for Cyanogen.
  • The other problem is that since Cyanogen caved in and became compliant to Google’s standards, it gave up its key selling point and hence, its appeal as an alternative to Google went to almost zero.
  • This combined, with suboptimal handling of the few handset makers that it already had on board meant that the outlook for Cyanogen making any revenues in the foreseeable future collapsed.
  • It appears that the workforce is being reduced by about 30% and the company is rethinking its strategy but I can see only one realistic option for this company (Recode).
  • There are two factors that make China a good fit for Cyanogen.
    • First: Cyanogen has a good implementation of Android and has a pretty good team of software engineers that understand some of the finer nuances of digital ecosystems.
    • Second: RFM research indicates that the next stage for competition in China is likely to involve much greater vertical integration for the likes of Baidu, Alibaba and Tencent.
  • Taken together it is not difficult to see how Cyanogen would be an excellent fit for ecosystems in China that need a platform.
  • Both Alibaba and Xiaomi and reasonably well advanced in creating their own platforms but both Baidu and Tencent look to be very far behind in this race with the China Mobile doing virtually nothing.
  • I think that buying Cyanogen and using it as their own proprietary fork of Android would provide a big step forward for these companies and could put them ahead of Alibaba which is currently leading this trend.
  • I think that this would be a better outcome for Cyanogen’s workforce and its investors as the current trajectory has it on the road to running out of money and closing down.
  • I think that this would be a real waste as Cyanogen has a good software asset and its development direction indicates a good understanding of the 7 Laws of Robotics which I think is essential for the success of any digital ecosystem.
  • Of all the companies in China, RFM research shows that only Baidu demonstrates a real understanding if these laws.
  • Unfortunately, I suspect that selling out to the Chinese would be seen as a big failure and I can see resistance to this option both inside Cyanogen and in its investor base.

I continue to think that having to close its doors, making it a distressed seller, is a much worse outcome for all concerned.

Wearables – Wrong direction

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Precipitous decline underscores the problem. 

  • It looks like demand for smartwatches has precipitously declined in Q2 16A, taking the overall outlook for wearables with it.
  • To me this is just another signal that the market is not ready for wearables mostly because no one has really figured out what to do with them.
  • Data from IDC (see here) is indicating that demand for smartwatches fell by 32% to 3.5m units in Q2 16A mostly driven by a decline in Apple Watch shipments to 1.6m units from 3.6m shipped right after its launch in Q2 15A.
  • Given that smartwatches are around half of the total market for wearable devices it is easy to see how the entire market could easily decline this year.
  • These figures bring into sharp focus the problem with wearables which is that no one really has any idea what to do with them meaning that most users are just not that interested.
  • To make matters worse, I can’t see this problem being fixed anytime soon.
  • The one exception to this is e-health where enabling users to track certain biometric characteristics could have substantial benefits for disease diagnosis and prevention.
  • Unfortunately, none of the devices are able to do this with anything like the kind of accuracy or reliability that would make it safe to rely on the data.
  • I have long thought that inaccurate health data is bad at best and dangerous at worst and so I do not see any real threat to the medical devices industry for now.
  • Currently, wearables are good enough to monitor biometric data for recreational and basic fitness uses but nothing more.
  • This makes a wearable nice to have but it still means there is no burning reason why a user must have one of these devices.
  • This has been echoed in Apple stores, where the Apple Watch tables are the least visited and the most asked question is “why should I buy one?”
  • This is why shipments of Apple Watch have been so far below bullish forecasts and why many users stop using a wearable within three months of purchase.
  • Consequently, I continue to think that wearables are little more than remote controls for a smartphone providing no reason for mass market adoption.
  • Of all the wearable players, Apple is likely fare by far the best as it has a very strong ecosystem which is critical to ensure differentiation.
  • Even Fitbit, which currently leads this market, is likely to struggle as it does not have the scale nor the experience outside of fitness tracking to put together a user experience compelling enough to keep its gross margins where they are.
  • Hence I think that 2016 will be very difficult for wearables in general as the ravages of commoditisation bite against a backdrop of increasingly indifferent users.
  • Apple is the only company in this space that I would consider investing in but its exposure to wearables is tiny relative to its market capitalisation.
  • Hence, wearables is not a theme in which I am looking to have exposure to for the balance of 2016.

 

Huawei vs Samsung – Rivers of blood Pt III

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Huawei flat-line passes advantage to Samsung. 

  • The first indications for the smartphone market in Q2 16A are pointing a loss of momentum for Huawei, Vivo and Oppo which will put a crimp in their plans to continue their rapid growth in 2016.
  • Huawei is of particular note as it has very aggressive plans to become No. 1 in smartphones indicating that it needs to employ a different strategy to continue gaining market share.
  • Production volume estimates from TrendForce indicate that Huawei’s share has remained broadly flat at around 9% while both Oppo and Vivo have also barely advanced from the 5% they had in Q1 16A.
  • Although, Samsung’s share of production is down a little, I suspect when it comes to sales to end users it has advanced slightly thanks to the popularity of the Galaxy s7.
  • The net result is that Huawei is no longer closing the gap on Samsung meaning that its global ambitions are grinding to a halt.
  • Huawei is now a comfortable No. 2 in Android but because Android devices are commoditised, that means that I see it making margins of 2-4% in the best instance.
  • In order to earn better margin, it must become the No. 1 in terms of volume and outsell its closest rival by a factor of more than 2 to 1.
  • It is this volume advantage that allows Samsung to earn 10-12% margins on Android devices which I think is sustainable for as long as it can maintain that volume advantage.
  • This is why to be successful, Huawei has got to do far more than just catch Samsung; it must outsell it by more than 2 to 1.
  • This will be very difficult to achieve which is why I think that Huawei is also working on differentiating its products through software and services.
  • If it can create a good user experience and services that users are prepared to pay something to have access to, then it should be able to make better than commodity margins.
  • However, this is easier said than done and I think that Huawei has a lot of work to do before it will be in this position.
  • This is why, I continue to believe that its best chance of success remains in China where a tie up with Baidu or Tencent could help it plug the service gap it currently has (see here).
  • However, this won’t help in developed markets and here Huawei must do everything that it can to develop the appeal and attractiveness of its Honor brand.
  • This will be difficult given the dominance of the Google ecosystem in these markets but I see cracks in Google’s position that might just give Huawei a chance.
  • Huawei’s commitment to this strategy will be sorely tested as it is going to be a long and hard road and handsets could easily lose a lot of money before everything comes right.
  • For the moment, the advantage has passed back to Samsung, who is also capitalising on popularity of the Galaxy s7 to extend its lead in terms of profitability.
  • This is why Samsung rests alongside Microsoft and Baidu as my top picks for 2016.

Microsoft FQ4 16A – Finnish with a flourish

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Good results restore optimism in strategy 

  • Microsoft reported good FQ4 16A results supported by signs of stabilisation in PCs and excellent performance in the cloud.
  • FQ4 16A revenues / adj-EPS were $22.6bn / $0.69 compared to consensus estimates of $22.1bn / $0.58 and RFM on $21.9bn / $0.59.
  • Microsoft’s strong results were driven by a very good performance by Azure which continued to grow by over 100% and some signs of stabilisation in the PC market.
  • This was slightly offset by gross margin pressure triggered by the increasing mix of revenues coming from cloud and Office 365.
  • This is completely normal as cloud revenues have lower gross margins than perpetual software sales but they are longer lasting meaning that they deliver more profit in the long term.
  • I would continue to expect to see gross margin decline steadily over the next year or two as this transition continues.
  • Stabilisation in PCs has been echoed by a number of other companies in the supply chain which have also seen some signs of stabilisation in the PC market this quarter.
  • I have long been believer that the PC is very far from dead but it is in fact suffering from a portion of its users continuing to defect to other platforms.
  • These users are the ones that I refer to as content consumers who have historically used a PC to do nothing more than browse the internet, email, shopping and so on.
  • These users have very little reason to own a PC as a smartphone or tablet running iOS or Android can do the job just as well and much more conveniently.
  • I think that other users such as content creators and companies will long have need of the PC and while I don’t think it is going to grow, I don’t see a precipitous decline either.
  • This is why I think that Microsoft’s legacy OS revenues are likely to stabilise as the OS tends to be sold as part of the PCs overall and therefore is likely flatten in line with the market.
  • The same cannot be said for Office but Microsoft is doing an excellent job at converting traditional Office sales into Office 365 subscriptions and there is every sign that this will continue.
  • Consequently, the outlook for the next fiscal year is good with steady revenue growth and tight control of the cost base.
  • However, the issue around the consumer assets remains unanswered.
  • Microsoft is increasingly becoming focused on prosumers and the enterprise and where assets like Bing, Xbox fit and Skype fit into that remains very unclear.
  • The good news is that Microsoft’s valuation does not demand any real action around integrating these assets to create a fully-fledged enterprise and consumer ecosystem.
  • Hence, I can still see these assets being sold off at some point which still gives me a valuation for the shares of around $62.
  • This is still nicely above current levels ($55) leading me to remain positive on the outlook.
  • I would also add Baidu and Samsung into this group of stocks to look at for the balance of 2016.

Yahoo Q2 16A – Slough of despond

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Another quarter marred by more of same. 

  • Yahoo reported another dismal quarter where it badly underperformed both its peers, Google and Facebook, as well as its potential in mobile.
  • Q2 16A revenue-ex TAC / adj-EPS were $841m / $0.09 compared to consensus at $840m / $0.10 as the core business continued to decline with mobile unable to make up the difference.
  • Display and search revenue both declined while mobile was only able to grow 3% YoY.
  • The only bright spot was advertising revenue driven by Yahoo Mail which further underlines that e-mail is rapidly becoming the only Digital Life service where Yahoo has real traction.
  • The majority of this traction is still coming from fixed internet where it is clear that there is very little growth.
  • When I take these results and compare them to Google, Facebook or even Twitter, the extent of Yahoo’s underperformance becomes clear.
  • This is further highlighted by the fact that I think that Yahoo should be earning over $2bn in revenues per quarter from mobile devices but its Q2 16 revenues were a tiny fraction of that ($259m).
  • I am expecting that most of Yahoo’s peers will report good results showing slow growth in fixed but very rapid growth in mobile.
  • In contrast Yahoo has reported declines in fixed and pedestrian growth in mobile underlining the extent of its failure to execute on the opportunity before it.
  • Fortunately for the share price, the story remains very much about the sale of the core business and on that basis it is not difficult to make the case for Yahoo.
  • I am pretty cautious on the outlook for Alibaba but even including that, it is not difficult to value Yahoo at $43 per share (currently $38) with upside to $51 per share if my view on Alibaba is wrong (see here).
  • Unfortunately, the sale of Yahoo’s core assets is dragging on and both management and the board are making heavy weather of assessing and selecting bidders for its business.
  • Verizon is still expected to come out on top and I continue to expect a sale price of around $3bn.
  • Consequently, it is very difficult to have a negative view on Yahoo as it still trades at a significant discount to the sum of its parts.
  • That being said I would feel much more comfortable with Baidu, Microsoft or Samsung for the short-term and Facebook or Apple for the longer-term.

Softbank & ARM – We’ll be back!

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I think ARM could return to the market in 5 to 10 years. 

  • SoftBank and ARM have announced that SoftBank will acquire ARM for GBP17.0 per share in cash representing a 43% premium and a total price of $31.6bn.
  • From ARM’s perspective the rationale for the deal is clear as:
    • First: ARM shareholders are getting a pretty good deal.
    • With the rapid slowdown in ARM’s core market and the difficulties being experienced by many of its customers, investors are unlikely to see GBP17.0 on the share price in the foreseeable future.
    • From that perspective ARM’s board have a fiduciary duty to accept an acquisition if it is deemed to be in the interests of shareholders.
    • Second: SoftBank has committed to substantially ramp up investments, particularly in IoT, which is something that as an independent company ARM would never have been able to do.
    • Third: SoftBank has committed to maintain ARM’s independence, pretty much exactly the way it is, which will have been critical to ensuring that customers, partners and users of ARM’s technology are comfortable with the acquisition.
  • However, from SoftBank’s perspective the acquisition is less obvious:
    • First: ARM is a long way outside of the sorts of areas where SoftBank has historically invested and there does not seem to any fit with anything else that it does.
    • Second: One potential reason for the acquisition would be to use ARM as the foundation upon which to build the next Intel but I am certain that this is a non-starter.
    • This is because there is no way that ARM’s existing customers and partners would stand idly by while SoftBank builds a competitor while owning technology upon which they have become dependent.
    • Third: The 30% appreciation of the Japanese Yen and the flat-line of ARM’s share price over the last 12 months means that the transaction is 30% cheaper for SoftBank than it was 12 months ago.
    • Consequently, this investment could be a vehicle for investing in the recovery of the pound but it looks like that SoftBank’s interest predates the recent 10% collapse in the GBP value.
  • It would appear that SoftBank aims to earn its return on the money invested through an expected appreciation of the GBP once Brexit has been executed and from returns on the investments that will now be possible by ARM.
  • I expect that these will be aimed at pushing ARM’s processor into more industry verticals such as servers, IoT, automotive and so on but also at increasing the degree to which ARM’s technology is used in device chips.
  • This will have the effect of both increasing volume (more devices sold using ARM) and increasing price (more ARM technology used in each device).
  • In the long-term, I can’t see any reason why SoftBank would want to hold onto this as there is no strategic fit, synergies or integration benefit to be had from owning ARM.
  • Therefore, I suspect that if SoftBank is successful at increasing’s ARM’s position through accelerated investments, we will see ARM return to the market in the form of another IPO just at a much higher level in 5 to 10 years’ time.

Nintendo – Poke in the eye.

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Apple and Google are the real & investible beneficiaries of Pokemon Go. 

  • Pokemon Go has nearly doubled Nintendo’s market capitalisation in the space of 8 days but I fear that it has all the hallmarks of a craze.
  • Hence, I worry that its appeal will soon die down meaning that it will fail to deliver the revenue and profits that the share price of Nintendo is now discounting.
  • Pokemon Go has come from nowhere to top the charts for both the Apple App Store and Google Play in every country where it has been launched and has become a global phenomenon in just 8 days.
  • Although it is free, Niantic has brilliantly capitalised on the desire to capture the virtual creatures and claim geographic territory, making the game the highest grossing app in every country where it has launched.
  • Consequently, the spreadsheet jockeys are already predicting that this could generate in excess $4bn in revenues per year and see a whole host of follow up products that will keep the revenues rolling.
  • This is where I get nervous because Pokemon Go has all the hallmarks of a craze (remember Crocs) of which most people will soon tire meaning that it could quickly disappear from the charts as fast as it has appeared.
  • Clash of Clans and Candy Crush have topped the app store charts for years and have built up a very solid and long lasting following which makes them far more dependable assets.
  • However, even if I am wrong, and Pokemon Go dominates the charts for a long period of time, how this benefits Nintendo is much less clear.
  • Nintendo does not own this game but owns a 33% stake in the Pokemon company which licensed the rights to Niantic in which I estimate that Nintendo owns a maximum of around 10%.
  • This means that Nintendo will only receive a fraction of revenues that the app generates.
  • If I assume that Pokemon Go generates $4bn in revenues, then Niantic will receive 70% of this or $2.8bn.
  • I estimate that Nintendo might receive $300m in the best instance which, as royalties and dividends, would all flow the bottom line.
  • The problem is that Nintendo’s market capitalisation already increased by $17.4bn valuing this profit stream at 58x.
  • This is way higher than Facebook where I am far more confident that profits will continue growing than I am with Pokemon Go.
  • Furthermore, the real beneficiaries here are Apple and Google.
  • Apple and Google will both receive 30% of all Pokemon Go revenues ($1.2bn in this example) as commission for selling it through their stores, again almost all of which, will fall to the bottom line.
  • These profit streams are both much greater and are being valued at a tiny fraction of what they are at Nintendo and so any investor wanting to load up on this fad should do so through these two companies.
  • Of the two, I prefer Apple as I continue to think that Aphabet’s shares are assuming that all remains well with Android which I fear is not the case.

Alphabet – Competition conundrum

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Google’s growth depends on how well it defends itself to the EU. 

  • Google has a very serious problem with the EU as the remedy that it is likely to impose, should it decide that Google has abused its dominant position, could end Google’s control of Android.
  • The long running EU complaint against Google is beginning to come to a head as Google now has until September 7th to respond to the statement of objections that the EU has put forward regarding its conduct on Android mobile devices.
  • There are currently two complaints active against Google.
  • One of these is to do with its dominant position in search where most of its revenues come from PCs and the other to do with whether Google has unfairly used its position in Android to stifle the services of its competitors.
  • I have long been of the opinion that the Android case has the most scope to damage Google’s outlook as RFM research indicates that without revenue growth coming from Android devices, Google’s growth will be very pedestrian indeed.
  • This has substantial implications for Google’s valuation as I think that the shares are already pricing in a continuation of its dominance of all Android devices outside of China.
  • The problem for Google is not the fine, which is likely to be around three month’s cash flow, but the remedy.
  • Here, I suspect the EU could force Google to stop requiring handset makers, who wish to use the Google Play app store, to put its core services front and centre on their.
  • These requirements are laid out in the Mobile Application Distribution Agreement (MADA) that each handset maker has to sign in order to get access to Google Play.
  • It is well known that it is almost impossible to sell an Android device in developed markets that does not have Google Play on it.
  • Google’s position is that it is “entirely voluntary” for handset makers to sign the MADA which I believe is a very misleading statement.
  • This is because if handset makers do not sign the MADA, they are unlikely to be able to sell material numbers of devices in developed markets.
  • This is why I believe that the MADA is entirely voluntary technically, it is effectively mandatory because there will be no meaningful handset sales without it.
  • I don’t think for one moment that the EU will be fooled by the “entirely voluntary” defence which is why Google needs to come up with a far more robust defence for its conduct in Android.
  • The one thing that Google has in its favour is time, as these proceedings can take years to be resolved.
  • The longer it takes, the more time that Google will have to become entrenched with users before it is forced to unbundle Google Play from its other services.
  • By that time, if Android users are already hooked on Google’s services, the need to have the MADA will be diminished as users will simply download the services to which they have become accustomed from the app store.
  • Hence, the longer the process takes, the less teeth the remedy will have.
  • The caveat to this is the power of default and the example set by Apple Maps and Internet Explorer.
  • Apple Maps is an inferior service compared to both Google Maps and HERE but it has managed to gain traction in iOS by being set as default with no option for the user to change it.
  • Internet Explorer’s market share has been gradually eroded over a period of many years since Microsoft was forced to unbundle it from Windows.
  • Consequently, I think that there is still a possibility that Google loses its entrenched position with users if the EU forces it to relax the MADA requirement, but it could take a long time.
  • Hence, I do not see an immediate collapse in Google’s revenues from Android should it lose to the EU but I would become much more concerned with its long term outlook.
  • I see this as all downside as I think that Google’s valuation is already discounting indefinite dominance of Android which is something that is increasingly looking to be under threat.
  • This is just another reason to reduce a position in Google.
  • I would look to Baidu, Microsoft, Samsung for the immediate term and Apple, Facebook and Tencent for the long term.

Apple – Replacement problem.

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The iPhone 6 is so good; it does not need replacing. 

  • The summer season of speculation, rumour and leaks of what will and will not be in the iPhone to be launched this September is already in full swing.
  • With loss of the headphone jack having been already put to bed (see here), attention has turned to the screen but I suspect that Apple is unlikely to be able to do what I think it will take to launch another major replacement cycle.
  • Top of the list of screen upgrades is a move away from regular LCD to Active Matrix Organic Light Emitting Diode (AMOLED) which would have an impact on the brightness, clarity and contrast of the images shown on the screen.
  • Unfortunately, even Samsung’s best marketing videos on how AMOLED improves the viewing experience fail to make me want to rush out and spend another $700 on a new iPhone.
  • I think that a large part of the problem is that the iPhone 6 is still almost as good today as it was nearly 2 years ago.
  • This means that the user needs to see something that either appeals to his fashion consciousness or meaningfully improves his Digital Life and I can’t see an upgrade to AMOLED providing either.
  • Consequently, I think that the upgrade in the brightness and clarity of what is already a perfectly adequate display is not sufficient to encourage users to replace what is already good enough.
  • However, if Apple were to do away with the side bezels all together and have a wrap-around screen that might just create enough excitement to trigger a cycle.
  • A wrap-around screen would not necessarily improve the function of the device but it would meaningfully differentiate it from its predecessors making the current generation look old and tired.
  • As many handset companies have found to their great profit, pointless gimmicks can sell vast volumes of mobile devices and I can’t see why Apple would be any different.
  • Unfortunately, I suspect that this year’s model is very unlikely to have this sort physical upgrade leaving the iPhone 7 or iPhone 6s II looking much like those that have gone before it.
  • As a result, there is very unlikely to be an upgrade cycle of anything like the size of what we saw in 2014 and 2015.
  • Therefore, I do not see Apple showing a sudden growth spurt which will disappoint those looking for a catalyst for the shares.
  • Despite this, I think there is value to be had in Apple.
  • It is a cash machine that is second to none, with an incredible global brand but it trades like a broken steel company.
  • Hence for those that have faith that Apple’s margins are unlikely to be challenged any time soon, this makes a great long term investment.
  • In the immediate term, I think Baidu, Samsung and Microsoft have more upside in terms of share price.

Alibaba – Bargain hunting.

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Patience pays off for Alibaba in the hunt for an app store.

 

  • Alibaba has announced that it has agreed to buy Wandoujia, one of the many Android app stores in China, which will fill a small but important hole in its ecosystem offering.
  • It looks like Alibaba will be paying around $200m to acquire Wandoujia which is a far cry from both the valuation ($1bn) at which it raised money in 2014 and the $1.5bn that Alibaba offered to buy it subsequent to the fund raising.
  • This strongly implies that while Wandoujia remains one of the larger app stores, it has really been struggling build a business around selling apps.
  • This comes as no surprise as the app store scene in China is extremely fragmented with the top 9 players needed to cover 90% of the market.
  • Wandoujia’s position has weakened materially in the last two years as RFM research indicates that it is now no. 8 in the market with just 3% share.
  • Tencent’s app store leads the market with 20% share, followed by Qihoo on 16%, Xiaomi on 15% and Baidu on 13%.
  • Until this acquisition, Alibaba had no position in the distribution of apps and services unlike its two main rivals in the Chinese market.
  • In developed markets, the app store is arguably the most valuable asset that an ecosystem can have as it is the core of Apple’s differentiation and Google method to control Android.
  • However, in China the situation is radically different as users do not tend to live in one ecosystem or another as almost everyone uses services from all of the big contenders.
  • This sets the scene for the next stage of competition where each of the ecosystems tries to entice users to spend more time with them at the expense of its rivals.
  • Here, RFM research indicates that controlling the software and in some cases, the hardware will be important.
  • Wandoujia is another piece of that puzzle and now I can see Wandoujia being the default app store on YunOS devices (see here)of which Alibaba hopes to ship 100m this year.
  • Of all the three BATmen (Baidu, Alibaba and Tencent), Alibaba is the furthest along the road in terms of developing a vertically integrated system by which it can deliver its Digital Life services to users.
  • Baidu and Tencent are far behind when it comes to vertical integration but I think Baidu has a better understanding of the ecosystem while Tencent has by far the strongest position in Digital Life.
  • Consequently, Although Alibaba is making the right moves to control its ecosystem, the content of such and the way it is delivered still needs a lot of work.
  • Despite being ahead in this area, I remain concerned that the market is over optimistic in terms of what it thinks e-commerce will deliver in China this year which is the main reason why I am cautious on Alibaba’s shares.
  • I continue to think that both Alibaba and Google look overvalued.
  • Baidu alongside Microsoft and Samsung remain my top picks for the immediate term but I am also keeping a close eye on both Apple and Tencent.