LINE – Talking Radio

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LINE expands its offering to keep revenues growing.

  • LINE has agreed to buy Microsoft’s free personal music streaming business, MixRadio in an attempt to expand its offering and keep growth going.
  • LINE is very far from being the biggest instant messaging with around 250m monthly active users but historically, it has been one of the best at monetising those users.
  • This has been achieved through the sale of stickers and games to Japanese users where monthly ARPUs have been as high as $0.30.
  • However, Japan is pretty much saturated and RFM research indicates that the users that LINE has outside of Japan spend less than one sixth of those in Japan.
  • With all of the future growth in users likely to come from outside Japan, this paints a bleak picture for the outlook of revenue growth.
  • MixRadio claims to have millions of users in 31 countries and this should help provide LINE with something to encourage ARPU’s to rise outside of Japan.
  • Inside Japan, LINE already has a music offering powered by its relationship with Avex Digital and Sony Music Entertainment.
  • This is yet another sign of how the instant messaging platforms are attempting to become ecosystems in their own right.
  • They have the advantage of being available across all major platforms meaning that developers that want to sell their content on these services only have to write their software once.
  • The disadvantage is that these are ecosystems within ecosystems meaning that all of the software is written in interpreted code.
  • The functionality of these services will be limited to the publically available APIs and performance will be severely impacted.
  • This is because the code has to be translated into machine code, executed and then translated back into the code that LINE uses before being rendered on the screen.
  • This makes it useless for any game that is heavy on graphics or is fast moving.
  • The acquisition of MixRadio will help LINE broaden its offering and encourage users to spend more time within its gated community but a lot more is needed before LINE can be classified as fully fledged ecosystem.
  • There is no immediate threat to the leaders but LINE’s ambitions are clear. 

Huawei – Pipe dreams

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Huawei offers very little threat to Xiaomi.

  • Despite slipping to number 5 in the Chinese smartphone market, Huawei has ambitions to return to its former glory.
  • It aims to accomplish this pushing launching its new Honor brand and emulating Xiaomi in every respect except the most important.
  • The Honor brand is aimed at younger Chinese users and will compete directly with the Xiaomi proposition.
  • The idea is to offer high-end performance at mid-tier pricing and to use online marketing, sales and after sales and service to reduce costs.
  • While this might make Huawei competitive when it comes to specification relative to price, Huawei is completely missing why Xiaomi has become successful in the first place.
  • Xiaomi is popular partly because it offers plenty of hardware bang for the buck but mostly for its Digital Life services that offer content consumption and instant messaging for Chinese users.
  • This is a large part of what makes Xiaomi desirable and underpins its ability to sell vast numbers of devices online with next to no marketing.
  • Monday’s analysis of Xiaomi (see here) strongly indicated that this does not come cheap and that Xiaomi is actually spending a lot of money on developing its ecosystem.
  • By contrast, Huawei is spending almost nothing and according to RFM’s research does not have any intention of developing an ecosystem of its own.
  • Consequently, it will continue to be seen by handset users as a commoditised Android maker, leaving with nothing to compete on other than price.
  • Even here it is struggling as its latest product the Honor 6 Plus sells for $404 compared to Xiaomi’s flagship Mi4 at $323.
  • Consequently, Huawei’s new ambitions to become No 1 in China and No. 2 globally within three years look like pipe dreams.
  • Until Huawei really understands what it is that makes Xiaomi so popular, it has very little chance of coming up with a winning strategy.
  • Xiaomi will not be losing any sleep over Huawei. 

Samsung vs. Apple – No pay day.

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A great payments service is not enough to stem the tide.

  • While Apple continues to expand the reach of Apple Pay, Samsung is looking to save its bacon with a competing offering.
  • This would bring Samsung into direct competition with Google Wallet and it is unclear how this relates to the non-compete agreement that the two companies have in the mobile ecosystem. (see here).
  • Apple has added another 10 banks to the Apple Pay system meaning that 90% of US card transactions could be supported by Apple Pay.
  • The piece that is still missing is the merchants where around 250,000 out of 3m retail outlets in US are NFC enabled.
  • Even if Apple Pay is wildly successful, its reach will still be limited as it will only be available on iOS devices which are in the hands of around 13% of smartphones users across the world.
  • This is the most lucrative 13%, but it still leaves plenty on the table for other offerings should they come up with offerings with similar ease of use.
  • To this end, Samsung has been in discussion with a company called Loop Pay and there is the potential for these two to solve each other’s problems.
  • Loop Pay consists of a piece of hardware that wirelessly transmits the data of the card to the sensor in the card terminal that reads the magnetic stripe.
  • This means that any card can be read by any terminal and LoopPay claims that its technology already works at 10m merchants worldwide.
  • LoopPay also includes an app. to manage all of the stored cards and to ensure that the appropriate security is observed when making a transaction.
  • There are two disadvantages:
    • First: The user still has to sign or enter a PIN to complete the transaction making using LoopPay no less onerous than using the original card.
    • Second: It requires the user to have a case on his device that turns it into a brick or to carry around an extra fob.
  • This is why LoppPay sells itself on “leave your wallet” at home rather than a much easier way to pay.
  • LoopPay expects to enable tokenised transactions in 2015E which should solve the first problem.
  • If Samsung integrates the LoopPay hardware into its mobile phones, this would solve the second problem.
  • RFM thinks that the LoopPay transmitter is small enough to be integrated without any impact on the size or weight of the device.
  • Hence, it is not inconceivable that Samsung and LoopPay together could come up with a solution almost as good as Apple Pay but how would this help Samsung?
  • LoopPay prides itself on supporting any card and a very large range of smartphones meaning that this is not going to be a service that is exclusive to Samsung handsets.
  • If it becomes successful, all the others will begin embedding the hardware as well meaning that any differentiation that Samsung would have created will be gone.
  • To keep it exclusive, Samsung will have to buy the company which is unlikely to come cheap given the hype that has been created by Apple Pay.
  • Consequently, I do not believe that this will save Samsung and that far more needs to be done if the Galaxy S6 and Note 5 are not to be yet more flops.
  • I still fear that Samsung’s handset business will test negative territory in 2015E and still see downside to KRW1,000,000 on the share price.
  • Microsoft, Google and Apple are far safer places to be.

Xiaomi – Reality Check Pt II

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Xiaomi disclosures push valuation even lower.

  • A disclosure to the Shenzhen stock exchange has revealed the reality of Xiaomi’s financial performance in 2013A.  
  • Xiaomi owns stake in Midea group and it was within this company’s disclosure to the stock exchange that the details were to be found.  
  • The key disclosure is that in 2013A Xiaomi had EBIT of $56.1m on revenues of $4.3bn or margins of just 1.3%.
  • This is a very far cry from the documents reported by the WSJ that claimed that Xiaomi had profits of $566m in 2013A.
  • According to Reuters, this $56.6m figure has been confirmed as accurate by Xiaomi.
  • Assuming that Xiaomi has gross margins of around 20%, this would give OPEX in 2013 of $804m or 18.7% of sales.
  • Given that Xiaomi relies mostly on viral marketing and Internet sales, I would estimate that Sales and marketing was 3% of sales at $130m with R&D at $674m or 15.6% of sales.
  • Xiaomi was pretty small in 2013E and given that it is trying to develop its own ecosystem, this figure looks to be about right.
  • In 2014E RFM estimates that revenues will be around $16.3bn (see here) with gross margins of around 20% giving gross profit of $3.2bn.
  • The key assumption here is R&D as the degree to which R&D has had to grow to support the development of the ecosystem is by far the biggest determinant of EBIT margin.
  • RFM also suspects that R&D has had to be massively expanded to support the ecosystem development but that some operating leverage has been achieved.
  • RFM estimates that Xiaomi has spent something around 13.5% of revenues in 2014E giving total R&D spend of $2.2bn.
  • Keeping sales and marketing flat at 3% sales would give total OPEX in 2014E of $2.7bn.
  • This gives EBIT of $500m or 3.1% of revenues in 2014E
  • With expansion in India already hitting a roadblock (see here) and the probability of having to pay royalties on Standard Essential Patents outside of China, margins are unlikely to rise in 2015E.
  • On 2015E revenues of $21.3bn (see here), flat margins would give EBIT of $660m.
  • Applying the same logic as before in comparing Xiaomi to Apple (see here) and putting this against Apples 10.3x 2014E and 9.1x 2015E EV/EBIT gives a valuation of just $5.6bn for Xiaomi.
  • If I then apply the same 300% premium as I did before to account for Xiaomi’s much higher growth, I end up with a valuation of $16.7bn.
  • Again the key caveat here is R&D. If Xiaomi has skimped on R&D to show higher profitability, then my short term figures could be way too pessimistic.
  • However, R&D is the life’s blood of growth and skimping here will crimp long-term growth meaning that my 300% premium to Apple would be too high.
  • I think that Xiaomi is capable of achieving higher margins but only when its ecosystem has firmly established itself and users are willing to pay up to have it on their devices.
  • I continue to think that money going into the company at $45bn is already assuming huge success in the ecosystem, all of which is very uncertain.
  • The only winners in a round at this valuation will be the existing shareholders and I would steer clear of this at any valuation above $17bn.


Facebook – De-Binged

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Facebook shows the critical nature of optimised experiences.

  • Facebook’s decision to remove Bing is very unlikely to be a sign that there is a new entrant coming to the search market.
  • Facebook recently updated the Graph search tool that helps users find old posts and content from friends and has removed external search results that were powered by Bing.
  • I suspect that this has more to do with the users getting confused between internal (Facebook) search results and those from the web rather than any sudden desire to run the searches itself.
  • In order to keep revenues growing, Facebook needs to keep as much traffic within its own systems as possible.
  • Directing users off its properties is effectively sending users away and in a number of instances, the information being sought is already present on Facebook.
  • Many thousands of business and services use Facebook for marketing purposes and removing external searches substantially increases the chances of the user remaining within Facebook.
  • I suspect that this also highlights that on mobile devices specific functions are best served by specific apps.
  • Mixing up social networking and search on mobile results in a sub-optimal user experience and I suspect that most users prefer an app for each function.
  • A great example of this is Facebook Messaging which was recently stripped out of the Facebook app and made into a standalone app.
  • The result has been a huge increase in activity such that Facebook is now the No 2. instant message network just behind WhatsApp.
  • Mobile devices are resource constrained when it comes to screen size, battery life and network bandwidth and capacity.
  • This means that apps and services need to be highly optimised in order to work well and hold user’s attention.
  • This essentially means one app. per function or service.
  • For the ecosystem players to be successful , a suite of apps. is necessary to address each facet of Digital Life optimally.
  • Both Google and Microsoft do this pretty well but others like Yahoo!, Amazon, Sony and Xiaomi have a very long way to go.
  • I continue to like Microsoft, Google and Apple (in the short-term) as places to look for gaining exposure to the digital ecosystem.  

Sony vs. Microsoft – Danger zone.

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Sony’s advantage already looks to be at risk.

  • Microsoft’s efforts to make up for the disastrous launch of the Xbox One are finally bearing fruit as the Xbox One outsold the PS4 in November.
  • The Xbox One and PS4 are very similar with the PS4 having a slight edge over the Xbox One when it comes to gaming performance.
  • However, the Xbox One is now $50 cheaper than the PS4 and almost always comes with a free game.
  • Most games are available on both platforms meaning that price is a major driver of the user purchase decision.
  • Sony is still miles head when it comes to the installed base but this development is yet another red flag.
  • The first red flag (see here) is the fact that the user experience on the PS4 is awful.
  • This is a big problem because the user experience needs to easy and fun to use so that users are encouraged to explore and find out what other cool stuff Sony has in its ecosystem.
  • The PS4 does none of this and the user experience is so bare bones and frustrating that all one wants to do is leave the UI as quickly as possible and play a game.
  • This is where Microsoft runs rings around Sony.
  • The Xbox experience is cool and fun to use and offers users plenty of reasons to have a look around and see what else is on offer.
  • This means that users are much more likely to discover other parts of the Microsoft ecosystem and become more engaged.
  • As it stands today, Sony has very little chance of this and the only advantage it has is a much larger installed base.
  • This advantage might not last long if the Xbox One continues to outsell the PS4.
  • Sony needs to urgently address this shortcoming by overhauling its user experience on the PS4 and making it at least as engaging as Microsoft’s.
  • This is where all the questions marks are to be found as Sony’s track record in this area is very poor.
  • If this can be achieved, then the experience can be rolled out across all of its devices with something that is uniquely Sony but above all fun.
  • Furthermore, Sony has many of the assets required to make this work with its portfolio of consumer devices and media assets.
  • It is from a position of strength (PS4) that Sony must develop its ecosystem and it also helps that gaming is the single most important Digital Life segment.
  • This is still an opportunity for Sony but as Microsoft gets its act together, that opportunity will become slimmer and slimmer.
  • Japanese companies have a habit of doing nothing until it is too late but I hope that Hirai-san knows this and has already acted.
  • Microsoft remains one of the best places to look for an investment in the digital ecosystem. 

Xiaomi vs. Ericsson – Bloody bandwagon.

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Patent royalties will pressure margins further.

  • Xiaomi has hit a road block in India as some of its products have been hit with a preliminary injunction following a complaint from Ericsson for infringement of Standard Essential Patents (SEPs).
  • India is Xiaomi’s first major foray outside of its home market in China and this is likely to be the first of several royalty claims that are lodged against the company.
  • The issue here is that most patent holders do not bother to pursue royalties in the Chinese market which is why this issue has only come to a head now.
  • When it comes to pursuing royalties, an objective assessment is made as to whether it is worth the effort and expense.
  • If unsuccessful, a patent claim can be very expensive for the plaintiff as the amount of research and the cost of legal services that are required are both very high.
  • As a result, it is extremely difficult to make a return on pursuing patent infringement in China which is why no one bothers with it.
  • However, the situation outside of China is very different and Xiaomi is now likely to end up having to pay SEP royalties on all of the products that it ships overseas.
  • Xiaomi has sought an open dialog with Ericsson regarding its liability and I suspect that it will end up paying a royalty of around 1% of the wholesale price of its devices to Ericsson.
  • This will open a floodgate and I suspect that Nokia, Google, Interdigital, Rockstar and some of the other industry consortia will also jump on the bandwagon.
  • The end result is likely to be an increase in costs of 5-7% for Xiaomi on all products that ship outside of China.
  • The one exception is Qualcomm.
  • Qualcomm is an early investor in Xiaomi and I suspect that Xiaomi is already paying royalties to Qualcomm and will continue to do so on its products outside of China.
  • This will have been already factored into Xiaomi’s planning and so does not represent an incremental negative for the company.
  • This will meaningfully compound Xiaomi’s difficulties when it comes to profitably selling devices outside of its home market.
  • This is because users in China buy the for their excellent Chinese-oriented media consumption services that the company offers in its devices.
  • Outside of China, these do not matter meaning that Xiaomi will be just another Android manufacturer. (see here).
  • Consequently, outside China Xiaomi is shipping a commodity meaning that’s it margins will be 2-4% in the best instance.
  • This will particularly be the case as Xiaomi specialises in offering phones with great specifications for a very good price.
  • The cost base is now likely to rise by 5-7% over the next few years which will pressure its margins even further.
  • While, I think that Xiaomi has a shot in its home market, its outlook overseas remains very bleak. 


Ecosystem economics – Cash triumvirate

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A third way to monetise may be about to emerge.

  • Microsoft’s pricing scheme for Windows 10 has yet to be released but it looks like it will have to rely on a new way to monetise if it is to make money from the smaller sized screen segment.
  • There are three ways to make money from the mobile ecosystem but only two of them have so far been shown to work well.
  • First: Monetisation through device pricing.
    • This is by far the most effective way to make money from an ecosystem, but it is also the riskiest.
    • The idea here is to have an ecosystem that is exclusive to a certain range of devices.
    • If the ecosystem is highly desirable then users will pay a premium price for the hardware in order to get access to the ecosystem.
    • This will deliver by far the greatest financial reward but it is also fraught with risk.
    • If the devices lose their differentiation or desirability then the device maker will quickly enter a death spiral of declining share and margins, probably ending up in loss making territory.
    • Furthermore, it is more difficult to see revenue growth from this method given the rapidly slowing growth in device markets.
    • Apple is currently the king of this method with Xiaomi, Sony and Microsoft also attempting to take this route.
  • Second: Monetisation through advertising.
    • This is the most common mechanism employed by ecosystem players.
    • Here, Digital Life services are offered to users in return for the right to use their personal data to sell targeted advertising to marketers.
    • This method is very popular with users, the majority of whom think they are getting the services for free.
    • This method delivers much less in terms of revenues and profits but I think that it is a much less risky method of monetisation.
    • For example RFM estimates that Google generates around $24 per Android user over the 2 year life of an Android device far less than Apple at around $600.
    • This method is less risky because great Digital Life services are much stickier than devices and there are much greater switching costs involved.
    • Google is currently the king of this method but Facebook, Yahoo!, Baidu, Twitter and many others are also making a good living in this way.
  • Third: Monetisation through subscription.
    • There are no clear examples of this method but I think that both Microsoft and Amazon may end up taking this route.
    • This method involves charging users a monthly fee for Digital Life services instead of targeting them with advertising.
    • This has the advantage of being able to offer users privacy and security, free from annoying advertising, but getting users to pay for something they think they can get for free elsewhere is extremely difficult.
    • This is why this model has yet to really emerge in a meaningful way.
    • (This commentary excludes services like Spotify or Netflix where users pay for specific content).
    • Amazon has made a start on this by bundling Amazon Prime with its free shipping option for $99 a year but has yet see any meaningful traction.
    • Amazon’s thinking around its ecosystem and device strategy remains very muddled and I am not optimistic that much is going to change in the short term.
    • With Windows now being offered for free on screen sizes of 7 inches and below, there is the possibility that Microsoft will also take this route when it announces its pricing for Windows 10 early in 2015E.
    • Microsoft already has some precedent here with subscriptions being charged for premium functionality on Xbox, Office 365 and Skype.
    • Consequently, I would not be surprised to see Microsoft announce a bundle of services on Windows 10 aimed at consumers for a small fee per month.
    • If the Digital Life services are good enough then I think that there is space for this method to work but it will have to work hard to win against an ecosystem that users perceive is for free.
  • I think that there is plenty of space in the market for all three of these mechanisms to flourish as they cater to different user preferences.
  • With ecosystem numbers likely to continue growing nicely even as device shipments slow, Microsoft and Google are likely to see better growth than Apple.
  • Apple still looks attractive in the short-term based on the iPhone 6 product cycle but the longer term growth picture looks better for Google and Microsoft.


LGE – Harsh reality

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Only volume can improve profitability.

  • LG’s latest moves show all the signs of a company that has come to terms with its commoditisation.
  • In many ways, LGE is currently better off than Samsung as it does not have the huge burden of expectations of high market share and profitability.
  • LG has been chugging along for years with mid-single digit smartphone market share and 2-4% margins.
  • Its devices have been commodities for a long time and its recent 10 year patent deal with Google (see here) is a sign that it has recognised and embraced that fact.
  • Underneath the surface of this deal is an arrangement where LG agrees not to compete with Google’s ecosystem on its devices.
  • For LG, losing the ecosystem is not a problem as it has no margins to protect, but for Samsung it has been a disaster.
  • Consequently, any preferential treatment that LG gets from Google as a result of this arrangement is a plus.
  • Now that it has accepted commoditisation, LG is looking for ways to maximise its profitability.
  • This is why I suspect that it will reduce the number of devices that it releases in 2015E.
  • Almost all of the profit in the mobile phone industry are made by one or two models and as devices commoditise users find it harder and harder to tell the difference between different devices.
  • This makes it increasingly pointless to make 2 devices that are almost indistinguishable as far as users are concerned.
  • Consequently, I suspect that only one of the LG G3 and LG G3 Pro will see a G4 version.
  • This will reduce R&D costs and is unlikely to reduce overall volume meaningfully giving a lift to profitability.
  • The problem remains that while LG is streamlining its cost base, the Android market continues to get more and more competitive meaning that any savings are likely to be eaten up in price declines.
  • Hence, I very much doubt that LG’s position will improve next year unless it can benefit from Samsung’s problems and take some share.
  • This would benefit margins through scale benefits and is the only way that I can see margins going up in 2015E.
  • I continue to think that the only beneficiary from the current situation in Android is Google whose ecosystem registers more traffic as more capable handsets are put into user’s hands at lower prices.
  • Google remains the only place to invest within the Android ecosystem.