Microsoft Q2 15A – Honeymoon ending.

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Honeymoon end obscures long term upside.

  • Microsoft reported in-line Q2 15A results but guided weakly as the corporate upgrade from Windows XP to Windows 7 has begun to tail off.
  • Q2 15A Revenues / EPS were $26.5bn / $0.71 compared to consensus forecasts of $26.4bn / $0.71.
  • However guidance was soft with Q3 15E revenues of $20.6bn – $21.4bn ($21.0bn) expected somewhat adrift of consensus at $23.7bn.
  • This was mostly due to the tailing off of the corporate upgrade cycle from Windows XP but the strong US$ has also been a factor.
  • However, expenses are now expected to be $1bn lower at $33.2bn-$33.6bn which will help offset the impact of lower revenues.
  • The problem is that the new emerging business that are growing well like Azure, Surface, Office 365, Xbox and so on are still too small to offset the impact of weakness in the PC market.
  • This means that until the ecosystem strategy really begins to blossom, earnings results will remain hostage to the PC market.
  • This is not all bad news as I think that as one replacement cycle ends, another much larger one could begin.
  • This is the replacement of the laptop form factor with portable computers where the keyboard is no longer attached to the screen.
  • The only product in the market today that lives up to the promise of being able to replace a laptop is the Surface Pro 3 but I am confident that many others will follow this year.
  • The big problem with this cycle is that users have been using the laptop form factor for over 30 years and have not realised that these devices are now obsolete.
  • Consequently, Microsoft, Intel and the PC makers need to embark on a campaign to help the user realise that there is now something much better and more useful available.
  • Unfortunately, no one in the PC industry seems to have any idea how to do this and they continue to try and sell tablet computers masquerading as laptops.
  • This strategy has no chance of succeeding and until the marketing strategy changes this replacement cycle will remain a dream.
  • Hence at least for the rest of this year, it looks like Microsoft’s performance will be largely be determined by the PC market.
  • The key catalyst for Microsoft will be when the PC industry realises that it has a game changing proposition on its hands and moves to capitalise on that opportunity.
  • Until then it is likely to steadily chug sideways.
  • There is still plenty of long term upside in Microsoft from the ecosystem angle but the short term catalyst is still not there.

 

Qualcomm & Samsung – Hot silicon

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Overheating very unlikely to be a Qualcomm design flaw.

  • There is enough noise in the market to make it likely that there has been a problem of some description with the Snapdragon 810 in the early version of the Samsung Galaxy S6.
  • These problems seem to have been bad enough for Samsung to consider dropping the Qualcomm processor from its flagship device which is due to launch right before Mobile World Congress in early March.
  • Under normal circumstances, Samsung has been using its in-house applications processor, Exynos, where it can and Qualcomm where it can’t.
  • Historically, this has meant that Exynos is used where performance is not critical and LTE is not used and Qualcomm where they are.
  • I am pretty sure that if the Exynos chipset family performed as well as its Qualcomm equivalent, Samsung would use it in all of its devices.
  • However, Qualcomm is the technology leader in this space and so far, the performance of its chips has tended to be significantly better than any in house equivalents.
  • This is not the first time that there has been a reported fault with a Qualcomm chipset, but it is the first time that the reported fault has been limited to just one handset maker.
  • LG is using the Snapdragon 810 in the LG Flex 2 and has reported no such problems.
  • The device is also in the Xiaomi Mi Note Pro Phablet and again there has been no sign of overheating.
  • Consequently, I suspect that there is something specific in the way that Samsung has implemented the Android software that is causing the chip to overheat.
  • This is not a design fault on the part of Qualcomm, but merely an incompatibility between the chip design and the way that Samsung has chosen to implement the Galaxy S6.
  • This will mean that Qualcomm will need to make some adjustments to its driver software to fix the problem which is something that should be accomplished reasonably quickly.
  • I do not expect Qualcomm to have to redesign the silicon which is a time consuming and very expensive process.
  • The net result is likely to be that Qualcomm remains a major supplier to the Galaxy S6 as Samsung badly needs this device to be a hit in order to regain some of the ground that it lost in 2014.
  • Running the device with just the Exynos processor runs the risk of the device underperforming its rivals and struggling with the integration of the processor with the LTE modem.
  • This is something that Samsung cannot afford and consequently I don’t think that Qualcomm is about to lose the socket in this very important handset program.
  • Either way this event is a PR boon for MediaTek which is quickly coming up the learning curve and eager to grab share at the higher end of the market. 

Google – Control freak.

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Google’s move to be an MVNO is all about control.

  • It looks very likely that Google will launch its own branded MVNO during 2015 using the networks of T-Mobile Inc. and Sprint. 
  • This is not good news for either T-Mobile or Sprint despite the share reactions to the news.
  • While they will get more traffic across their networks, they will come closer to being bit pipes leaving all the real value for Google.
  • Google has a habit of launching idiosyncratic projects like floating retail stores, Internet balloons, Space X and the like but this one appears to have a real purpose.
  • The Google ecosystem has two big problems.
    • First. The user experience on Android is not nearly as good as iPhone or even Windows Phone.
    • The major factor behind its problems is the chaotic and random nature of Android where the user has to be his own systems integrator.
    • This is what causes its lower usage and lower loyalty and I believe that this makes it vulnerable to market share loss.
    • Second. Google has no control over the distribution of its mobile services software.
    • Despite being launched for nearly 8 months and available for 3, Lollipop (5.0) is present on less than 0.1% of Google Android devices in the hands of users.
    • By contrast iOS8 is on 71% of all Apple devices and achieved 33% within one week of release.
    • All of the great innovations and improvements that Google has made are currently sitting on the shelf getting old while everyone else copies and improves on them.
  • The only way in which Google can fix these weaknesses is to take control of the software and ensure that its ecosystem into the hands of the users how and when it wants.
  • By creating its own MVNO, it will have a much bigger route to market for its Nexus devices where it has soup to nuts control.
  • It will also be able to create incentives to get users to buy the devices and set tariffs to encourage usage of its ecosystem.
  • This is why I think Google may be taking this route and shareholders of T-Mobile and Sprint should not be rejoicing as it will only accelerate their commoditisation.
  • Google increasingly looks dominant in its segment of the market and is well set up to reap almost all of the benefits of having an ecosystem.
  • It has already bent the handset makers to its will. Now it is the turn of the mobile operators.
  • I continue to like Google alongside Microsoft and Apple as places to be when considering investing in the mobile ecosystem.

Microsoft – The price is right.

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Free upgrade is excellent news for the Microsoft ecosystem.

  • Microsoft’s ambition to become an ecosystem company have crystalised further as upgrades to Windows 10 from 7, 8.1 and Windows Phone will be free.
  • Microsoft gave a deeper preview of Windows 10 at its event yesterday and at the same time launched its own foray into the world of virtual reality with Microsoft HoloLens.
  • With Windows 10, the somewhat geriatric and clunky Internet Explorer will be phased out to be replaced with Project Spartan.
  • This is a new browser based on open standards that puts content front and centre and will have Cortana the digital personal assistant integrated.
  • Internet Explorer will still be available for corporate customers that have legacy systems that require it, but it is Spartan that will be offered as the recommended option.
  • Much of the commentary and demonstrations were focused around the integration of Microsoft’s Digital Life services to make them more intuitive, functional and easy to use.
  • This is precisely what I want to hear because aside from its inability to market its wares effectively, integration is the ecosystem’s biggest challenge.
  • Digital Life services need to share user data in order to make themselves more relevant and easy to use and they also need to know how the user lives his Digital Life in order to be more useful.
  • At the moment, Microsoft’s Digital Life services exist as a series of discrete offerings with a very thin veneer of single sign-on.
  • The way Microsoft discussed functionality gives me hope that it has internalised the problem and is moving to integrate all of its services together.
  • This is a messy, difficult and time consuming task but one that I hope is well underway in the back rooms at Redmond.
  • The HoloLens wowed the press but the big news of the day was without doubt the free upgrade for existing users.
  • I suspect that this, together with Spartan, is all about making the software as consistent as possible across all devices and about making life as easy as possible for developers.
  • By making the software free, Microsoft can guarantee that uptake of its new software and Digital Life services will be excellent.
  • This is especially the case as like Apple, Microsoft controls the distribution of its software.
  • Google does not and is currently looking somewhat foolish as less than 0.1% of Android devices have made the upgrade to Lollipop (5.0) despite the software being available for months.
  • Having much greater software consistency across PCs, tablets, phones, Xbox and other hardware will give developers more devices to target and also improve the performance of Microsoft’s own Digital Life services.
  • HoloLens looks interesting with its focus on augmented reality rather than virtual, but the hardware still makes the user look and feel very silly.
  • Here an unsung part of Microsoft might be able to do something interesting.
  • In my opinion, Microsoft has become one of the leading designers of hardware in the technology industry.
  • The fact that Microsoft designed (in house) the most difficult parts of the Surface Pro 3, the superb Arc mouse, the heart rate sensor on the band and many other designs lead me to believe that Microsoft is a force to be reckoned with in hardware.
  • Hence, I think it entirely possible that this competence could be used to redesign the HoloLens to be something small, light, unobtrusive or even cool.
  • The end result is that this was a good day for Microsoft.
  • It has taken further steps to disengage with its past and is making all of the right moves to ensure that its ecosystem is a contender for both the consumer and the enterprise.
  • If the marketing message can be fixed to explain to users why they should get involved rather than just telling them that it exists then things could quickly change.
  • Consequently, I remain positive on Microsoft’s ambitions which combined with Google and Apple, make up the best way to get involved in the mobile ecosystem. 

HP – The eggs have landed.

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HP loses more face over Autonomy.

  • The end of the criminal investigation into HP’s allegations of fraud at Autonomy leaves the management of HP with egg all over its face.
  • The UK Serious Fraud Office (SFO) has declined to proceed with fraud charges against the former executives of Autonomy stating that there is not enough evidence to be confident of a conviction.
  • The US investigation will continue but I am almost certain that it too, will decline to proceed to formal charges.
  • This is because, while HP is a US based company, Autonomy was listed in the UK and consequently that it is the jurisdiction where any crimes are most likely to have been committed.
  • Consequently, it seems even less likely that there will be enough evidence for the FBI to press formal charges.
  • It increasingly looks like the original conclusion that I drew over two years ago (see here) will finally be proved correct.
  • Ever since HP purchased Autonomy for $11bn, and less than 12 months later wrote of $5.5bn of that value, it has been clear that HP failed to do its due diligence properly.
  • Autonomy was a listed company, and the market was well aware that one needed to tread very carefully when looking at Autonomy’s published figures.
  • Furthermore, it appears that HP was made aware of many of the contested issues prior to the closing of the deal (see here) but chose do nothing.
  • Consequently it is increasingly clear that while Autonomy’s accounting practices could be seen as aggressive, they remained within the rules.
  • It comes as no surprise to me that the SFO has declined to prosecute and I am sure that the FBI will do the same.
  • This will leave HPQ’s management with little option but to admit that it failed to fulfil its obligations to shareholders when carrying out its due diligence.
  • I would not be surprised to see the filing of a class action lawsuit against HP.
  • This is unfortunate as HP has done a reasonable job in cutting costs and getting the ship back onto an even keel.
  • However, the company remains without any real strategy for its long-term future and the split into Hewlett-Packard Enterprise and HP Inc. solves nothing.
  • I continue to think that HP will continue to drift along allowing most of the technology industry to pass it by. 

Xiaomi – Circumnavigation.

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Xiaomi must have exclusive services to succeed.

  • Xiaomi is following in the footsteps of its rivals in building an ecosystem via purchasing small shareholdings but this is not enough.
  • Most recently, Xiaomi has purchased 2.98% of productivity software company Kingsoft for $68m.
  • This is in addition to a $205m purchase of a 1.98% stake in home appliance maker Midea and participation in the most recent fund raising of wearables maker Misfit.
  • Kingsoft is a producer of freemium software that competes against Microsoft Office and Google Docs.
  • Kingsoft also has a web browser called Leibao and a position in Internet security (Cheetah Mobile).
  • When I look at Xiaomi’s position, it is clear it has embarked on a trip around the Digital Life Pie.
  • RFM research shows that Xiaomi’s services currently covers just 17% of the activities that users do on their smartphones.
  • In order to have a successful ecosystem and to be able to command premium pricing (and hence margin), it needs to expand this offering.
  • Users need to identify with Xiaomi as the place where they want to live their digital lives in order for Xiaomi to earn a premium return on hardware in a similar vein to Apple.
  • This is why Xiaomi (and many of the other Chinese players) are actively engaging in M&A which is unlikely to stop until it has solid coverage of the pie.
  • Xiaomi is also looking at making its ecosystem available on many different form factors and devices explaining its interest in Misfit and Midea.
  • Kingsoft provides Xiaomi the opportunity to cover the Enterprise Digital Life pie and to compete against Microsoft and Google’s offerings.
  • This is all well and good but in order to make this work, Xiaomi needs to offer exclusive services.
  • Kingsoft is also part owned by Tencent, which I believe will be one of Xiaomi’s fiercest rivals in the coming years.
  • Hence, anything that Kingsoft delivers to Xiaomi will also be available to Tencent meaning that there will not be a sustainable competitive edge for Xiaomi should Kingsoft become important in mobile.
  • This is where Xiaomi’s biggest weakness lies.
  • Its main rivals, Tencent Alibaba and Baidu are all much bigger and much stronger meaning that they can out bid and out-invest Xiaomi is almost anything.
  • This is why it will be very difficult for Xiaomi to develop a thriving ecosystem in its home market unless it creates its own services from scratch.
  • This will take huge investment which will keep margins under pressure in the medium term even if the strategy is wildly successful.
  • This is why I think Xiaomi is a real stretch at $45bn and why Lenovo’s IPO will offer its investors much better value at 5% of the valuation (see here).

 

 

BlackBerry – Roller-coaster.

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There is no reason why Samsung would want BlackBerry.

  • BlackBerry has had a wild couple of days as rumours surfaced that Samsung was willing to buy BlackBerry for around $7.5bn or $14.4 per share.
  • This is what was responsible for a 29% rally in the share price only to be almost all given back today after both Samsung and BlackBerry denied the rumours.
  • They were categorical in their statements in saying that no discussions relating to an acquisition of BlackBerry by Samsung had taken place.
  • In this case the swings have been particularly wild because of the very high level of short interest that exists in the stock.
  • Currently, Bloomberg estimates that there are short positions (sold the stock without owing it) that are equivalent to 26% of the number of shares in issue.
  • To close these positions, 26% of the shares in existence would need to be purchased explaining the panic buying when there was a possibility that holders of short positions would incur nearly a 50% loss.
  • This also explains the degree of scepticism in the market with regards to the possibility that BlackBerry can make a profitable recovery.
  • The emphatic denials on both sides confirms my opinion that there is no reason why Samsung would want to buy it.
  • The opinion that Samsung would want to buy BlackBerry for its patents is a non-starter for two reasons:
    • First. BlackBerry’s patents are not actually worth that much. RFM has previously estimated that the portfolio could be worth around $1bn which has been independently corroborated by industry practitioners.
    • Second: If Samsung was desperate for patents it could have purchased Mototola Mobility from Google for a third of the price or taken advantage of the ongoing disintegration of Rockstar (see here).
  • Consequently, I can see no reason why Samsung would want to buy BlackBerry as:
    • There is no synergy in terms of platforms or costs.
    • Samsung already has an enterprise offering through KNOX and could take customers from BlackBerry organically, obviating the need to buy them.
    • Samsung itself is trying to right size its ship for the likelihood of much lower margins going forward and is in no position to take this on, even if it could find a good reason to.
  • Samsung has managed to hold its handset business steadier than I thought during Q4 but remains very far from a recovery.
  • This combined with my concerns around the long term outlook for BlackBerry leads me to steer clear of both of them for now.

 

 

 

Samsung Tizen – Ducks and Chickens.

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Duck in danger becomes chicken and egg.

  • Samsung has at last launched a handset based on Tizen’s software.
  • The device is called the Z1, has been launched in India and will cost just over $90.
  • It was 5 months ago that Samsung delayed its handset yet again citing the need to “enhance the ecosystem”  (see Tizen – Duck in danger).
  • What it actually meant was “give us time to strip it down to be as low cost as possible” to fit it into a pricing category where users only care about price.
  • With no ecosystem on Tizen, the only way to sell a device is using price.
  • At $90, the Z1 is significantly cheaper than Xiaomi’s entry level Redmi product which can be had for $130 but then its specifications are somewhat underwhelming.
  • The Z1 features 4” screen, 1.2Ghz dual core processor, VGA/ 3.1MP front and rear cameras, 768MB RAM and 4GB internal storage.
  • In contrast Microsoft’s Lumia 435 (also launched today) features a 4” screen, 1.2Ghz dual core processor, VGA/2MP front and rear cameras, 1GB RAM and 8GB internal storage.
  • Critically the Lumia 435 is 23% cheaper than the Z1 and for once is able to boast that it has more apps available.
  • Furthermore, Microsoft offers a fairly complete and robust ecosystem which knocks the socks of Tizen which has nothing.
  • Despite this, I suspect that the real competition for the Z1 is going to be from the low end devices from the likes of Micromax, Spice, Karbonn and so on.
  • Indian consumers are not very wealthy but they do already seem to have internalised what Android is and often demand it as a prerequisite at the point of sale.
  • Against this the Z1 has no answer and will have to be sold on the back of Samsung’s brand and its marketing dollar.
  • By having a handset running Tizen, Samsung is beginning to spread Tizen across many of its devices which could be the beginnings of proper cross device strategy.
  • This is badly needed to support flagging handset profitability where its Android devices are now commoditised and pretty much controlled by Google.
  • That being said, to make this work Samsung needs to deliver fun and easy to use Digital Life services on Tizen devices.
  • If there are none of these services then there is little point in any of these devices talking to each other as there will be nothing to say.
  • So once again the fundamental limitation of Tizen is exposed: it has no Digital Life services from which to create an ecosystem.
  • Failure to create one will lead to Tizen competing against Android purely on hardware.
  • Because Tizen will always be much lower in terms of volume, there is no way it will be able to match prices and still be a viable proposition for the vendor.
  • This is the difficult chicken and egg situation where Tizen finds itself.
  • Without some volume there will be no Digital Life services and without Digital Life services there will be no real volume.
  • Hence, I remain pretty cautious on the outlook for Tizen but it is now certain than Samsung is far more committed to Tizen than it seemed 6 months ago.

 

Lenovo – Cash Call

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Lenovo offers far more value than Xiaomi.

  • Following the acquisition of Motorola Mobility from Google, it looks very much as if Lenovo has realised that to get a thriving handset business one needs vast investment.
  • Lenovo has announced that is considering a public listing of its mobile device business at some point in the future.
  • Lenovo plans to make this business more than just handsets by expanding into smart home and other types of connected devices.
  • The aim here is to have this financed by money from the public markets not just from Lenovo.
  • I think that the reality is a little more straight forward
  • In order to develop its mobile device business, significant investment is needed and Lenovo simply does not have the money.  
  • Following the acquisition from Motorola and the server business from IBM, Lenovo has spent almost its entire war chest and there is very little left for further investment.
  • The PC business is faring reasonably well but it continues to exist on wafer thin margins meaning that there is no real cash cow from which to source investment into something new.
  • Consequently, funds need to come from outside in order to invest in the consolidation and development of the mobile device business.
  • The valuation of the business is expected to be a couple of billion dollars at IPO which comes as a great surprise.
  • Lenovo (including Motorola) shipped 25.2m units in Q3 14A and 28.1m units in Q4 14E.
  • This is somewhat ahead of Xiaomi on 18.0m and 17.4m respectively.
  • This represents smartphone share of 7.8% and 7.9% respectively giving Lenovo 3rd position in the global smartphone market.
  • Upon these devices it was probably slightly loss making with the losses of Motorola Mobility added in for those quarters.
  • Xiaomi ships fewer devices than Lenovo, has only slightly higher margins but somehow commands a valuation more than 20x that of Lenovo.
  • To me this is more a reflection of how crazy the $45bn valuation of Xiaomi is rather than Lenovo selling itself short.
  • Xiaomi has the potential to reap big rewards from developing its own ecosystem but at $45bn a huge amount of success in this regard is already being priced in leaving very little upside.
  • Furthermore in the Chinese market Xiaomi will have to contend with the ambitions of Tencent, Alibaba and Baidu all of whom are working on their own ecosystems and have far more money to invest.
  • With a valuation of a couple of billion and a solid strategy to develop a wider range of devices even commodity margins could lead to significant upside for investors.
  • I would regard an IPO of this business at the discussed valuation as extremely interesting and worthy of further investigation. 

Enterprise Ecosystem – Pole position

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Office 365 is reaping the rewards of change.

  • Microsoft’s change in attitude towards Office software is starting to reap real rewards.
  • Only 12 months ago, in order to use Office a user had to have Microsoft Windows as its operating system.
  • On iOS and Android, third party applications were available where a user could read Office documents but the experience was so bad that converting the file to Google or something else was a preferable option.
  • The management change at Microsoft has brought in a completely new attitude towards its strategy and how to sell its products.
  • The Windows everywhere mantra has gone to be replaced with a strategy designed to persuade users rather than force them. 
  • To that end Office apps were made available on iOS and users can now read and edit documents without paying Microsoft a cent.
  • This is does not mean that the PC is losing its relevance but it does mean that users are increasingly doing certain tasks on more than one device.
  • Furthermore, its cloud offering, Office 365, puts all of these apps together into a complete enterprise ecosystem and makes it available on any device that the user owns.
  • Office for Android is still in the works but I expect it to be launched during 2015.
  • This is why cloud platform providers are seeing Office 365 rapidly rising in the ranks of installed applications and why I think Flurry saw productivity as the second fastest growing category on mobile in terms of usage over the last few months.  
  • Not only is Office 365 rising in terms of installs but it is used more frequently than anything else (Okta.com).
  • I believe that this will lead to decline in the usage of alternative offerings such as Google Docs, iWork and so on.
  • These alternatives were created as alternatives to Office but now that pricing is far more reasonable and the causal user can get access for free their appeal is starting to wane.
  • Consequently, I suspect that Office 365 will continue to gain traction over the short and medium term.
  • Salesforce still remains the number one cloud application used by companies but Office 365 is quickly catching up.
  • There is still a very long way to go as less than 33% of companies have migrated their IT into the cloud (Gartner) but Microsoft already has its ducks in a row and is in pole position.
  • Microsoft remains the only company with a comprehensive offering for both the consumer and the enterprise ecosystem.
  • Consequently, if it can find a way to marry the two in a single experience that is both fun and easy to use, it will have achieved a very strong competitive edge.
  • Microsoft remains one of my favourite ways to have exposure to the increasing importance that the ecosystem will play in the generation of revenues and profits in the technology industry.