Facebook & Twitter – Black and white

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Facebook and Twitter going in opposite directions. 

  • Facebook and Twitter report very different results, highlighting the gulf between the haves and the have-nots in the digital ecosystem.

Facebook Q2 16A

  • Facebook reported very strong results as it continued to improve the degree to which it is able to monetise its users on mobile devices.
  • Q2 16A revenues / adj-EPS were $6.44bn / $0.97 well ahead of consensus at $6.01bn / $0.82.
  • Steady progress was made during Q2 16A with total MaUs reaching 1.71bn of which 1.57bn access Facebook via a mobile device.
  • Messenger and WhatsApp are now comfortably past 1bn MaUs, with Instagram passing 500m during Q2 16A.
  • Mobile now makes up 84% of total advertising revenues and user engagement with Facebook’s services continues to progress.
  • Facebook Live is also seeing traction and has been used several times to broadcast important current affairs.
  • This is very bad news for Twitter, which jumped onto the live video broadcast bandwagon first with Periscope, but is now at risk of becoming irrelevant.
  • The outlook for Facebook remains strong but I am increasingly concerned that expectations have more than caught up with the shares.
  • The fact that the shares rallied just 5% in after-hours trading is warning enough, but RFM’s monetisation model also indicates that growth may slow significantly in H2 2016E.
  • This is because Facebook still only occupies 35% of the Digital Life pie and without greater coverage, the monetisation opportunity is limited.
  • Facebook is working on this but I have long been of the opinion that its new strategies will not become revenue generating in time to meet consensus expectations.
  • Although I see Facebook as potentially becoming the biggest ecosystem of them all, I think that there will be a much better time to get involved in the stock.
  • I am holding off till then.

Twitter Q2 16A

  • Twitter reported another dismal set of results as it guided Q3 16E revenues well below expectations.
  • Q2 16A revenues / adj-EPS were $602m / $0.13 compared to expectations of $607m / $0.09 but guidance fell far short.
  • Q3 16E revenues are expected to be $590-$610m ($600m midpoint) way below consensus at $681m but broadly in line with RFM at $607m.
  • RFM’s estimate is based on its monetisation model for digital ecosystems which estimates revenues based on Digital Life coverage, MaUs and performance against the 7 Laws of Robotics.
  • Although users did expand to 313m during Q2 16A, Twitter’s fundamental problem remains the fact that it only covers 16% of the Digital Life pie explaining its lack of growth.
  • This is why its deal with the NFL is so important.
  • If Twitter can generate traction upon its platform from the 8 or so games it will be broadcasting in H2 2016, then it stands a chance to resist being swamped by Facebook Live Video.
  • Assuming this is successful and Twitter can build upon this foundation, then Twitter could have a media consumption offering which would increase its coverage to 26%.
  • This would then give it scope to entice users to spend more time on its platform and thereby start growing revenues once again.
  • However, this is very far from reality and I still have concerns that a part time CEO is exactly what Twitter does not need at the moment.
  • Hence, I can see Twitter becoming an acquisition target but with no growth now becoming the clear reality, interest is likely to start once the shares trade below $10.
  • I am still very cautious on Twitter.

Apple Q3 16A – High yield

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Apple as a bond is yielding 9.8%. 

  • Apple reported better than expected Q3 16A results as the iPhone SE sold better than its predecessor, the iPhone 5c, despite a much larger than expected channel inventory reduction.
  • Q3 16A revenues / EPS were $42.2bn / $1.42 compared to consensus at $42.1bn / $1.39.
  • As usual all eyes were on the iPhone which shipped 44.4m units to end users compared to consensus at 39.9m but did so at a lower price as ASPs were $595 compared to consensus at $605.
  • This is what was responsible for the better than expected results but iPad and Mac also fared reasonably well.
  • iPad shipped 10.0m units compared to consensus of 9.1m and the iPad Pro helped ASPs improve to $490 from $415m.
  • Mac shipped 4.3m units compared to consensus of 4.4m underscoring slow but steady market share gain in the PC market.
  • Q3 16A Services revenues grew by 19% YoY to $6bn underscoring that developers are faring better on iOS and are increasingly preferring to develop their apps for this platform before considering Google Play.
  • Guidance was also positive with Q4 16E revenues / gross margins expected at $45.5bn – $47.5bn ($46.5bn midpoint) / 37.5% – 38.0% (37.8% midpoint) slightly ahead of consensus at $45.8bn / 38.4%.
  • These good results underpinned another very strong quarter of cash flow with $10.1bn generated from operations, $13bn returned to investors leaving gross cash down slightly at $231.5bn.
  • With debt unchanged at $72bn this leaves the net cash position at $159.5bn.
  • Although the market was clearly relieved that the declines were not as large as had been feared, these numbers do nothing to alleviate Apple’s current problem.
  • In the eyes of the stock market, Apple has to produce growth in order to command a higher valuation and of this growth, there is no sign.
  • This is why Apple is unlikely to receive a rerating of its shares until it branches out into a new product area.
  • Apple Watch saw declines this quarter (see here) and I think that while Apple is building a car, it will never launch it (see here).
  • This leaves Apple unlikely to see much in the way of growth but it is continuing to distance its ecosystem from Google’s.
  • This gives me confidence that its superb profitability and cash flow are likely to remain intact for some time to come.
  • On that basis, I like to think about Apple equity as a bond and on that basis it is currently paying a coupon to its owners at a run rate of $52bn per year.
  • Hence, equity holders are earning a yield of 9.8% per annum with a very low risk profile.
  • For those that are not worried about capital growth, this is a no brainer as most companies with bonds yielding 10% are highly distressed.

Yahoo – Fire sale

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Long-term investors pay heavily in lost opportunity.

 

  • Only in the context of Yahoo’s awful execution over the last 4 years can the sale of its operating business be called a good deal for investors.
  • Yahoo has agreed to sell its operating businesses excluding cash, patents and investments to Verizon for $4.83bn in cash which is expected to close in Q1 17.
  • This is higher than I had been anticipating ($3bn) and in that context (see here), I can raise my valuation of Yahoo from $43.3 per share to $45.2.
  • This is also assuming that my bearish view on Alibaba (see here) is correct.
  • If I use the current share price of Alibaba, then my current valuation of Yahoo is $54.6 some 43% above the current share price of $38.3.
  • Hence for those that are considering buying Yahoo’s shares now for a quick profit, things are looking good but I think that long-term Yahoo investors are faring very badly.
  • This is because for the last 4 years Yahoo has had a huge opportunity to migrate the substantial traction that it has in fixed internet into mobile.
  • However, through poor execution, I think this opportunity has been completely squandered.
  • Even without games, Yahoo still has 41% coverage of the Digital Life pie and it claims to have 600m monthly active users.
  • If I take these figures and apply them to RFM’s monetisation model, I estimate that if Yahoo had executed as well as Google, Facebook or Twitter, it should have generated $2.1bn in revenues from mobile devices alone in Q2 16A.
  • In reality, Yahoo generated revenue of $259m from mobile, just 12% of its potential, highlighting just how badly Yahoo has failed to address mobile correctly.
  • If this potential had been fulfilled, then I think that Yahoo’s core assets could easily have been valued in excess of 10x the price that Verizon is paying for them.
  • This is why I think that long-term Yahoo shareholders have paid dearly for the missteps of the current management team and why this fire sale can be of little consolation.
  • I doubt that Verizon will able to do much better with these assets and in that context Google and Facebook can focus on competing against each other in mobile and not worry too much about Yahoo.
  • I still think that Yahoo shares will end up trading meaningfully higher than where they are today based on the sum of its parts and so it is worthy of consideration from that perspective.
  • Elsewhere, Baidu, Microsoft and Samsung remain my top short term picks but I am keeping a very close eye on Tencent and Facebook where I am looking for the right time to enter.
  • I remain negative on Alibaba, Google and Twitter.

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.