MWC Day 3 / Samsung vs. Google – Brass tacks

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Samsung has no choice but to push into the ecosystem.

  • Samsung and Google have signed a 10 year patent agreement but there does seem to be more involved than just a simple IP cross licence.
  • The first sign of this is that the media hubs through which Samsung was selling movies and music have disappeared from the Galaxy S5.
  • It is no secret that these hubs compete directly with the Google Play store and it seems logical that Samsung has removed them as part of the agreement it made at the end of January.
  • There is speculation that the new Magazine UX on the TabPro may be dumped as well as its instant messaging application ChatOn.
  • All of these are aimed at promoting Samsung Digital Life Services over those of Google.
  • Very little is known about the agreement between Google and Samsung but whatever has been agreed, nothing can change the reality that Samsung currently faces.
  • That reality is a harsh one.
  • Unless Samsung makes a successful migration into the ecosystem, its handset margins will return to 5-10% over the next few years.
  • This means that whatever it has agreed with Google, it must remove Google from its devices and encourage users to live their Digital Lives with Samsung rather than Google.
  • This is because hardware continues to commoditise and Samsung’s ability to differentiate in hardware and user interface will erode over time.
  • This means that other devices will be equally good and equally fun to use, removing the user’s ability to tell the difference and his willingness to pay a premium.
  • Hence, Samsung must develop its own services if double-digit margins are to be preserved.
  • If it can create a great ecosystem (that’s a big if) then these should only be available on Samsung devices and then users will be willing to pay up for the devices to get the services.
  • One possibility is that Google’s end of the agreement is to make its services optimised for Samsung devices such that they perform better on Samsung devices compared to anyone else.
  • This would have the effect of Samsung’s devices being preferred by users of Google services giving Samsung pricing power and hence margin.
  • This is a risky strategy as Samsung only has half the market for Android meaning that Google will have effectively alienated the other half, leaving them probably looking for something else.
  • Furthermore, if this is the case, I can see anti-competitive complaints being made to regulators regarding unfair competition by these two companies.
  • This is the only scenario in which I can see Samsung agreeing to move closer to Google and promoting Google’s services over its own.
  • Handsets make up 75% of Samsung Electronics’ EBIT and if margins fall to 5-10% (from 17% in Q4 13A), then the share price could easily halve.
  • It is extremely unlikely that Samsung would voluntarily sign up for this future and so I suspect that the Samsung services strategy remains fully active.
  • Its recent commentary to the media also indicates that this is the case.
  • Hence, I continue to expect Samsung to fragment the Android ecosystem and to throw Google off its devices in the long run.
  • Anything else leaves Samsung with a reality that no company trying to create value, would ever take lying down.
  • Samsung is cheap but it has a huge hill to climb and it has to make a dangerous enemy leaving me preferring the ecosystem upstarts of Yahoo! and Microsoft.

 

MWC Day 1 / Nokia – Middle age spread

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The suit count is way up making Nokia and Android the most exciting development.

MWC Day 1

  • MWC 2014 has attracted more visitors than ever but the void of news flow hallmarks what is becoming an increasingly mature industry.
  • The jeans and t-shirts which were rare in 2013 are now almost extinct and continue to be replaced with endless dark grey suits.
  • This is not a negative sign but it shows that the industry is becoming middle aged.
  • The smartphone is now mainstream and will grow at about half the rate in 2014 that it did in 2013.
  • Add in 10% ASP erosion and the addressable market revenue growth will be in mid-single digits best case.
  • This underlines Radio Free Mobile’s view that the place to look for growth in the medium term remains the ecosystem.
  • Ecosystem users are set to grow nicely over the next three years and companies that are exposed to the number of users rather than handset shipments will see much better growth.
  • Look for Google, Microsoft and Yahoo! And forget about HTC, BlackBerry, LGE and other commodity plays. 

Nokia – X hits the spot?

  • Nokia X is not Android. It is Nokia trying to get the Windows Ecosystem into price points that Windows Phone cannot yet touch.
  • Nokia has launched a series of devices based on Android but this is much more about pushing the Windows Ecosystem than it is about going off in a new direction.
  • Android is an operating system upon which ecosystems can be built.
  • First and foremost of these is Google which consists of non-open source software that provides access to all of its services including the Google Play app store.
  • Nokia only has access to the base level Android OS which is becoming increasingly basic as Google moves more and more of the functionality into GMS (Google Mobile Services – the software that sits on top of Android).
  • Nokia has taken this base piece of Android and implemented as much of the Windows Ecosystem on top of it that it can.
  • This has the advantage of allowing the Windows Ecosystem to reach lower price points that it can today and also of running Android apps.
  • Nokia claims that most Android apps will run without any porting at all.
  • However, one can be pretty sure that the cool apps that most users will want (ones that involve network access) will require some degree of porting. 
  • To help the platform’s appeal to developers and users Nokia is enabling operator billing for apps through its store.
  • It has agreements in place with 160 operators in 60 territories that will allow users to pay for apps and services via their telephone bill or prepaid credit.
  • This removes one of the hurdles for developers in terms of getting paid and also makes like easier for the users many of whom will not want or not be able to use a credit card. 
  • The biggest problem with this offering is the price.
  • The cheapest device is being offered at $120 putting it squarely in the low to mid-range of Android.
  • This may not be enough to wean users of the Android ecosystem and, just like Windows Phone, a great experience at retail will be required to entice users to make the switch.
  • This has been badly executed by Microsoft in 2013 but I hope that the company has learned that putting a blank device in the hand of a user is not enough.
  • This is especially the case when one is coming from behind.
  • There is still a huge amount of ground to make up but a good marketing campaign behind this offering could give the Windows ecosystem a badly needed leg up.

Firefox OS – Who pays the piper?

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Firefox enables a $25 smartphone but it is hard to see how anyone makes money from it.

  • For the last year Firefox OS has promised mid to high level smartphone performance for a mid to high level feature phone price.
  • It got the price right but the performance really lagged which combined with spotty operator commitment meant that volumes meaningfully disappointed.
  • Radio Free Mobile has forecasted that Firefox shipped around 1.3m devices during 2013 but only 425,000 unique users have actually visited the Firefox marketplace since the devices went live in July 2013.
  • This strongly implies that there are less than half a million users in the ecosystem compared to my estimate of 1.2m.
  • I think that this is largely due to spotty operator commitment where refusal to commit to certain volumes has meant that entire programs have been cancelled.
  • The launch of the Huawei (Firefox OS) and ZTE (Open C) phones are big upgrades to what has gone before but are still unlikely to effectively compete against Android at the same price tier.
  • However, Firefox has taken the bull by the horns and the latest version of its OS enables a $25 smartphone.
  • At the heart of this design is the SC6821 from Spreadtrum which offers Cortex A5 @ 1Ghz, 1GB embedded DRAM and 2GB of external NAND flash.
  • The reference design includes a 3.5inch HVGA screen, 0.3MP camera, 2G EDGE, WiFi, Bluetooth and FM radio.
  • This is not exactly exciting in the smartphone world but at $25, this measures up impressively against budget feature phones in this price tier.
  • The lack of 3G removes a lot of cost as does the external 2GB memory that the user will have to purchase on top of the price of the device.
  • It is clear that massive compromises have been made to hit this price point, but it still stacks up very well against other feature phones in its price range.
  • So the vital promise (see here) now becomes: Mid to high feature phone performance at a very low feature phone price.
  • Essentially, Firefox is attempting to get in underneath the lowest end of Android, the falling price of which made its 2013 offering obsolete before it even launched.
  • If this promise can be met and the operators can be made to commit to big volumes then Firefox could see some meaningful traction and take up of its ecosystem.
  • However, one big problem remains. I can’t see any takers for this reference design.
  • This is because it is so low priced that it will be extremely difficult to any OEM to make even the thinnest of margin without massive volumes.
  • While the operators might be convinced to commit to more volumes than before, I doubt they will commit in anything like the size needed for an OEM to have the confidence to make the devices.
  • This is exactly what killed the GSMA’s “3G for all” program in 2007 where LG could not secure commitments from operators for the KU250 to be able to make a decent return on the device.
  • It seems that history will once again repeat itself and unless operators can be made to really step up, this device will not make it off slideware. 
  • The promise has changed but the game remains pretty much the same.
  • Firefox has a promise to keep to see some real traction and there is a huge hill to climb to get there.
  • That being said, if operators are prepared for once to live up to their protestations of support then this promise might just be kept.
  • This is more likely to happen than before and so I think the chances for Firefox have improved somewhat compared to where it was last year.

Facebook– Whats up?

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There is a lot “up” with Facebook to justify spending $19bn of shareholder’s money on WhatsApp.

  • Facebook will pay $4bn in cash, $12bn in shares and $3bn in restricted stock to acquire WhatsApp, trumping Google’s bid of $10bn.
  • My current estimate is that WhatsApp currently has around 475m users which means that Facebook is paying $40 for every user who generate $1 per year in the best case scenario.
  • My suspicion is that in fact it earns far less than that as it has no way of collecting the annual fee for many of the users of the service.
  • My estimate is that revenue is in fact $0.5 per user per year and I think I am being generous.
  • This gives me a fair value of WhatsApp of around $4bn or so meaning that Facebook is going to have to move mountains to earn a decent return for its shareholders on this acquisition.
  • However, I am sure that Facebook’s motives go far beyond instant messaging and in fact I think that this acquisition is about Digital Life.
  • WhatsApp is not about to increase Facebook’s user count but it will give it a dominant foothold in hottest Digital Life service at the moment: instant messaging.
  • Facebook has a very strong position in one segment (social networking) of Digital Life but it has very little outside of that.
  • Furthermore, all of its efforts to build new services outside of that space have been total failures.
  • In order to secure long term revenue growth it must do well in encouraging its users to do other things with its service other than social networking.
  • Instant messaging on its own is a small piece of the Digital Life pie but I suspect that Facebook has big plans for this platform.
  • LINE, KakaoTalk and others have extended their IM services into platforms that do other things like gaming and this could be very interesting for Facebook as gaming on smartphones is extremely important.
  • RFM research shows that users spend 32% of their time on smartphone playing games and if Facebook can use WhatsApp like LINE then this could do wonders for the value of its ecosystem.
  • Strategically, I don’t have a problem with this acquisition as something needed to be done about Facebook’s position in Digital Life and the organic options were not working.
  • However, the valuation paid is so high that I really struggle to see how investors will ever see a positive return on this investment.
  • It is a great comfort that only $4bn is being paid in cash (which ironically I find to be about the right value) with the rest being paid in already pretty expensive paper.
  • I suspect that this was a factor in the acquisition price.
  • Had it been all cash, with Google not in contention then I suspect WhatsApp would have got something more like $10bn.
  • Facebook’s strategy is right in making this acquisition but much greater value for the shareholders would have been generated if it acquired KakaoTalk.
  • KakaoTalk has superb monetisation already and probably would have been much cheaper but then the two CEOs would not have had such cozy dinners together.

 

 

 

 

 

 

 

Research Publication – Mobile Ecosystems – The second derivative

Radio Free Mobile publishes its second piece on mobile ecosystems with the publication of:

Mobile Software – iRobot. (Click here for details and purchase options)

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It is time to look for the second derivative. Smartphones have been the belle of the ball so far but the place to now look is the ecosystem. This is because ecosystem users are likely to continue growing long after revenue growth in the smartphone market has fallen to zero. Here RFM would look to Yahoo!, Baidu, Google and Microsoft and forget about trying to eke out a painful commodity existence in Android.

 

  • Low puff. The smartphone market is running out of growth and this year prices could easily fall hard, resulting low or no revenue growth. Commoditisation is everywhere and where 6 months ago Samsung and Apple were sitting pretty, even they now are feeling the pinch. This investment theme is out of breath.
  • High puff. On the other hand the ecosystems appear to have lots of growth left in them. There are currently around 1.5bn mobile ecosystem users globally which RFM expects to more than double by 2017E to 3.5bn. Any business model that has exposure to user numbers rather than smartphone shipments has a much stronger basis for growing revenues over the next few years.
  • Myth. Most commentators think that the ecosystem war is over with iOS having 30% of the users and Android 70%. While this is an accurate split of operating systems it bears no resemblance to reality when considering the ecosystems. The main reason for this is that Android is not an ecosystem. It is an operating system upon which a number of ecosystems are based.
  • Reality. There are three big ecosystems with more than 300m subs. (iOS, Google and China), Two medium sized ecosystems with more than 100m subscribers (Yahoo! and Samsung) and a number of small ones all trying to become viable. 100m+ subs are needed to be viable and 300m to make a proper return.
  • Investment positioning. First and foremost Radio Free Mobile is looking for companies with exposure to the size of the ecosystem rather than device shipments. In that regard Yahoo!, Baidu and Google immediately move to the top of the list. Facebook and Twitter are also candidates but they are both seeing slowing growth in their user counts. Microsoft is also a contender but this piece is so small inside the company that it is more a play on a recovery in PCs than it is an ecosystem investment. Apple is likely to be hobbled by falling hardware margins and has significant problems when it comes to delivering an ecosystem of its own. Commodity Android should be avoided at all costs.

 

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Samsung – Gear up MWC

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Galaxy Gear could steal the thunder next week.

  • Samsung is launching its new line-up on Monday evening at an event in Barcelona.
  • While the Samsung Galaxy S5 is likely to be one of the most boring launches of the show, there could be some interest around the Galaxy Gear.
  • The Samsung Galaxy S5 is likely to feature a slightly larger screen with higher resolution and a slightly better camera and that’s about it.
  • What is more interesting is the possibility that the Galaxy Gear 2 could be running Tizen rather than Android.
  • This would then be running Samsung only services and could be seen by many as the beginning of Samsung’s move off Android and onto Tizen.
  • I would refine this view to: this could be the beginning of Samsung’s move off Android in devices where the app. store does not matter.
  • The Galaxy Gear has a small screen and is really only a remote control for a smartphone.
  • Hence almost all of the Android apps will be irrelevant on this device and therefore there is less of a need to run Android.
  • I can see the same thing happening in televisions, fridges, home automation and so on but in smartphones and tablets Android remains critical.  
  • This fits with Intel’s activities where it is using Tizen for automotive infotainment and televisions
  • A move to Tizen in mobile phones where the app. store and the developers are critical makes no sense at all.
  • Android is open source (if you exclude the Google apps.) and there is nothing stopping Samsung from taking Android and making it its own just like Amazon has done.
  • That way it takes control of its software and is asking very little of developers when it comes to migrating from Google Android to its own version.
  • This will be much easier than asking the entire ecosystem to migrate from Android to Tizen.
  • Furthermore, Tizen is not strictly under Samsung’s control.
  • It is an industry consortium which is means standardisation by consensus.
  • This always results in slower development and a solution that does not fully meet everyone’s needs.
  • History is littered with the graves of companies that have tried this approach and I suspect that Samsung is not about to risk its entire handset business on Tizen when it has a better and safer option.
  • Net net, I am not expecting much in the way of surprises from Samsung next week and continue to think that the short term outlook for the company and the stock is a bit dull.

HPQ – Eggs in flight

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The fight between HPQ and Autonomy is going very badly for HPQ.

  • It looks increasingly likely that HPQ will have egg all over its face when the Serious Fraud Office and the FBI decline to press charges of fraud against the former management of Autonomy.
  • HPQ purchased Autonomy for $10.8bn in 2011 and then followed that up by writing down the acquisition by $8.8bn a year later.
  • HPQ has justified this acquisition by saying that it was wilfully defrauded by the former management of Autonomy.
  • I love long argued that the real issue here is that HPQ failed to do its due diligence at the time of the acquisition. (see here and here and here).
  • This is exactly what is emerging (via the FT) and furthermore it appears that it was aware of many of the contested issues before the deal closed.
    • First: HPQ has claimed that loss making hardware sales were used as a way of making up shortfalls in software revenues.
    • Autonomy often sold hardware as part of its software contracts and while many of the sales booked are questionable, they do not appear to be fraudulent.
    • Autonomy’s auditor Deloitte signed off on these transactions.
    • Finally, HPQ was notified of the existence of these hardware revenues and how they were being recognised, during the seven months after the deal was announced but before it closed.
    • HPQ had every chance to object but appears to have done nothing.
    • Second: Autonomy’s use of resellers is being called into question. Under IAS, a company is allowed to book a sale to a reseller even if there is no end client as long as it is a final sale with no come back.
    • E-mail evidence (via the FT) strongly indicates that:
      • 1) HPQ was aware of these transactions during the seven month period between the announcement and the deal closing.
      • 2) HPQ requested that Autonomy recognise these revenues as deferred revenue as required by US GAAP.
    • Again it appears that HPQ had every opportunity to dig into these issues in more detail before the deal closed but failed to do so.
  • These types of transactions may be aggressive and questionable but they are not technically illegal.
  • Hence, it looks very much like that both the SFO and the FBI will decline to prosecute this case leaving HPQ’s management looking very foolish again.
  • This will leave HPQ’s management with no option but to admit that it failed to fulfil its obligations to shareholders when carrying out its due diligence.
  • This is the last thing that management needs as it has done a reasonable job in cutting costs and getting the ship back onto an even keel.
  • The eggs are in the air and they look almost certain to hit HPQ squarely in the face.
  • Management is fortunate that its shareholders are only focused on the future.

 

Viber / Rakuten – History lesson

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  • This deal looks eerily similar to Ebay’s unsuccessful purchase of Skype in 2005.
  • Rakuten, The Japanese B2C and B2B2C e-commerce platform has announced that it will buy Viber for $900m.
  • Viber is very similar to Skype except that it was developed for mobile first meaning that it has been designed with mobile in mind.
  • Skype is primarily a fixed line platform and the performance of its clients on mobile devices is average at best.
  • That being said it is far more established than Viber which has 300m users and no revenues to speak of.
  • Running Viber through a valuation exercise and comparing it to the likes of SnapChat, LINE, Kakao Talk and WhatsApp gives a valuation of around $1 per user with no monetisation.
  • LINE and Kakao Talk have much higher valuations per subscriber because they are able to generate significant revenues from their user base.
  • This gives me a fair value of Viber of around $300m.
  • This means that the other $600m is for “strategic value” to Rakuten.
  • This is all well and good but we have seen an ecommerce platform try this before.
  • eBay purchased Skye in 2005 in order to allow buyers and sellers communicate with the click of a button and this is exactly the reason that Rakuten has given for making this acquisition.
  • Two years later eBay wrote down Skype by 35% (or $900m) as there appeared to be very little value added to the users and no one was using it.
  • In 2009, it sold 70% of Skype to investors including Silver Lake who turned it around and sold the business to Microsoft for $8.5bn.
  • All ended well for eBay but the original reason for buying Skype turned out to be a very bad idea.
  • This is why I think that the real reason for buying Viber has to be a competing offering to LINE and Kakao talk which have done a superb job of moentisation their home markets of Japan and South Korea.
  • Viber has already launched stickers and I can see Rakuten pushing the platform into games and other such media that have proved very popular and very profitable in Japan and South Korea.
  • If Rakuten can monetise the Viber platform to the same degree that LINE and Kakao Talk, then this is a good acquisition.
  • However there are two main problems:
    • First. LINE and Kakao Talk’s monetisation outside of their home markets is a tiny fraction of what they get at home and it is outside of Asia where Rakuten will be mostly looking to monetise Viber’s users.
    • Hence, the outlook of squeezing more than a few cents per user per month from users is very bleak indeed.
    • Second. This is no longer virgin territory. LINE and Kakao Talk have already grabbed the market and Rakuten will have to entice these users away.
    • This is a much more difficult, expensive and risky proposition.
  • If Rakuten can make this work, then I can see a good return on this acquisition as I would value it at around $2.3bn if Viber were to see the same kind of success as LINE.
  • However, this is going to be very difficult to achieve and Viber will have to much better and much more innovative to make it work.
  • History has shown that there is no value for an e-commerce platform from this type of acquisition and realising a decent return for Rakuten investors is a very difficult proposition.
  • Japanese companies have a habit of overpaying for assets at the peak of their value, and in all likelihood this will be no different.

Tizen – Noise without substance

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The latest news from Tizen is unlikely to change anything.

  • Despite its leading supporter shelving its plans to launch devices, the Tizen association has announced a raft of new members and plans to show devices at MWC on 23rd February.
  • Tizen is not new. It is the remnant of a plethora of industry consortia that have spent the last 10 years trying to come up with an industry standard upon which to build a Linux based mobile phone.
  • As support and cash have dwindled, these consortia have all merged with one another to form the Tizen project which is now part of the much larger Linux Foundation.
  • The Tizen project is mostly driven by Samsung as it has written almost all of the code and produced the ill-fated 360 handsets for Vodafone in 2009.
  • Until recently, Tizen has also been strongly supported by NTTDoCoMo which has been planning to launch handsets on its Japanese network.
  • However, its launch of the iPhone and the dominance of Android in its network is a clear signal that there is no space for Tizen based devices at this time.
  • This is especially the case as there is no ecosystem, applications or services for these devices meaning that user appeal would be virtually zero.
  • Hence, NTTDoCoMo has indefinitely shelved its plans to launch Tizen devices (see here) leaving the platform in limbo.
  • The association has just welcomed 15 new members including Baidu, Softbank and ZTE which is bound to be trumpeted as a new beginning for the beleaguered platform.
  • In reality, I suspect that these new members are simply exploring their options in a world where Android is a commodity and all of the value is being generated by the Google ecosystem, leaving them with PC margins at best.
  • Using something other than Android could allow these players to cut the apron strings to Google and this is why I suspect they have signed up.
  • However, there is no point in using Tizen when one can use the open distribution of Android and still enjoy some compatibility without being beholden to Google.
  • Hence, I suspect that these new members will have a look at the code to which they now have access, and reach the same conclusion that NTTDoCoMo has and decide to do nothing.
  • I am expecting some noise and new found enthusiasm for Tizen at Mobile World Congress but once the dust has settled it will just be more of the same.
  • If one wishes to change the trajectory of a projectile, one has to apply a force to it.
  • Nothing has changed at Tizen and so its downward trajectory also remains unchanged.

Lenovo Q3 – Narrow squeak.

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Lenovo can absorb Motorola and just avoid red ink

  • Lenovo will be skating on very thin ice when it absorbs Motorola as the handset maker is so unprofitable that it could push Lenovo into the red.
  • Lenovo reported good Q3 results as it gained share in PCs but margins remain wafer thin.
  • Q3 Revenues / Net income were $10.8bn / $265m compared to forecasts of $10.5bn / $244m.
  • Lenovo has done well in PCs gaining share again in all regions taking global share to 18.5%.
  • Share in smartphones was stable with 13.5m units shipped.
  • Despite the good news, margins remain wafer thin with EBIT of just $334m or 3.1%.
  • There is logic in taking on Motorola Mobility (see here) but it is going to put a massive dent in Lenovo’s very fragile profitability.
  • Motorola Mobility has been losing around $200m per quarter for the last few years and there is no sign of this changing.
  • Hence, when Lenovo takes on Motorola margins will immediately collapse to just 1.2%, all thing being equal.
  • Furthermore, I expect that large parts of Motorola’s existing operations will be closed down resulting in a restructuring charge of at least $500m.
  • Once the Motorola brand has been migrated to Lenovo’s existing products, then there should be some traction but it is going to take time.
  • Together Motorola and Lenovo had 6.4% of the smartphone market in Q4, moving into third position, just ahead of Huawei and LG.
  • This is not going to be enough to see decent profitability as Android is increasingly going to require scale to earn a reasonable return and so large swathes of market share will need to be won.
  • I estimate that to see a reasonable return on this investment, Lenovo needs to increase market share to at least 10%.
  • This will put some leverage into the business and allow margins to improve from the commodity margins earned by most of the Android camp.
  • The combination of Lenovo’s manufacturing and Motorola’s brand is a good start but a heavy sprinkling of marketing magic will be required to achieve a level of volume where margins will be acceptable.
  • Hence, I think that Lenovo’s margins are going to head south for at least the rest of 2014E and I am not at all confident that it can succeed where so many have failed.
  • That being said it has done a good job in PCs although it has been unable to lift profitability despite being the clear market leader.
  • Something special is needed if this is not to be a major disappointment and I would not be rushing to buy the shares of Lenovo just yet.