Microsoft & Amazon – Different days

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Microsoft and Amazon have a very different day.

Microsoft FQ2 16A.

  • Microsoft reported steady results as Office 365 and cloud services more than offset the weakness in the PC market.
  • FQ2 16A revenues / Adj-EPS were $25.7bn / $0.78 compared to consensus at $25.3bn / $0.71 and RFM at $26.5bn / $0.71.
  • Adoption of Windows 10 continues at a better pace than Windows 7, with 200m active devices and usage of those devices also showing encouraging signs.
  • Bing reported some progress in gaining 1% point of share to 21% in the US Search market but 30% of Bing’s search revenue now comes from Windows 10 devices.
  • Given that Windows 10 makes up less than 15% of Windows devices in the market, this implies that the usability improvements are encouraging users to interact with Microsoft’s services to a greater degree. .
  • This bodes well for the adoption of Microsoft as the go to ecosystem for Digital Work but the questions marks around Digital Life remain.
  • Both Office 365 and Azure grew far faster than the corporate average and it was these two businesses that drove stronger than expected revenues.
  • Guidance for Q3 16E was in line with expectations with revenues of $21.6bn – $22.2bn just shy of consensus at $22.2bn but further progress on expenses and optimism on the cloud won the day.
  • I suspect that there was also considerable relief that the outlook for the coming quarter was less impacted by economic volatility than many had feared.
  • The net results was 4% rally in the shares in after-hours trading.
  • Microsoft’s stock has had a difficult start to 2016 but these results indicate that it is likely to weather difficult times better than average.
  • Microsoft’s progress on the consumer ecosystem remains slow and hesitant but fortunately the valuation demands no success at all.
  • Hence, there remains plenty of upside if it gets it right but still some upside even if it does not.
  • This is why I continue to like the stock going into 2016.

Amazon Q4 15A

  • I consider Amazon to be a true unicorn but one that has a habit of stabbing itself with its horn.
  • Amazon once again dashed the market’s hopes by returning once again to investment mode at the expense of profits.
  • The result of this slip was a 13.4% decline in the share price I after hours trading.
  • Q4 15A revenues / net income were $35.7bn / $743m well short of consensus at $36.0bn / $1.3bn.
  • The revenue miss was almost entirely due to the strength of the US$ but the real problem was profits which missed expectations by 43%.
  • Amazon’s continued push into faster fulfilment as well as technology and content investments did the damage as both of these saw increases as a percentage of revenues.
  • Amazon Web Services put in a mighty performance growing 69% YoY to $2.4bn with operating margins of 28%, but seeing as this is still a very small part of revenues its positive impact was minimal.
  • Q1 16E guidance was also soft with revenues / EBIT of $26.5bn – $29.0bn / $100m – $700m well short of consensus at $27.7bn / $800m.
  • Amazon has two truly mighty machines: its retail offering and Amazon Web Services and both of these are doing very nicely.
  • However, it is the other areas that need urgent attention.
  • The profits from these two power houses are being spent on a haphazard series of experiments and futuristic thinking for which there are virtually no results no date.
  • For these experiments to pay off, Amazon has to think about how to put these investments together in a way that creates a cohesive, integrated and delightful experience for users outside of online shopping.
  • This means that Amazon needs to understand the importance of the Digital Life ecosystem and of this there is no sign.
  • Consequently, I think that Amazon’s outlook remains as haphazard as its strategy making for more wild swings on results days.
  • At 110x 2016E PER, there is absolutely no room for error making this a stock to avoid this year.
  • Apple’s earnings are far more reliable and are more than 90% cheaper making it the obvious choice when choosing between these two.

Facebook Q4 15A – Sleeping Policeman

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There is a bump in the road ahead.

  • Facebook reported very strong results as revenues from both mobile and fixed saw stronger Q4 seasonality than I had been expecting.
  • This combined with increasing optimism around Facebook’s resistance to a slowing economy sent the shares up 12% in after-hours trading.
  • Q4 15A revenues / EPS were $5.84bn / $0.79 compared to estimates of $5.37bn / $0.68.
  • Facebook generated had 1.44bn mobile users who generated 80% of Q4 15A revenues or $4.67bn, ahead of RFM’s estimate of $4.35bn.
  • These strong figures were driven by both the price that Facebook charged for its ad. inventory and an increase in total ad. volumes highlighting the probability of further market share gains.
  • Facebook is able to charge higher prices for its mobile ads as its understanding of its users and hence the accuracy of its targeting is better on fixed than it is on mobile.
  • Facebook is optimistic for 2016E but expects that there will be some drag from the strength of the US$ as well as tougher comparisons to the excellent year just completed.
  • I agree with Facebook’s view that it remains reasonably insulated from economic woes as most of these are coming from China where it is not present in any meaningful way.
  • However, profitability in 2016E is likely to fall as the company is budgeting for 30% – 40% growth in OPEX and I very much doubt that revenues will keep pace.
  • Furthermore, I am much more cautious than management on the year ahead especially for the second half.
  • This is because Facebook is getting close to fully monetising the segments that it occupies in the Digital Life pie meaning that it needs to expand its coverage to keep growing.
  • I see Facebook heavily engaged in doing just that with Oculus, Messenger, WhatsApp, Video and Facebook M but these are going to take time to come to fruition.
  • Consequently, there is a real risk that Facebook runs out of growth before the new drivers become mature enough to take over the mantle of growth.
  • I think that this could happen in H2 2016 and I would not like to be long Facebook when this realisation hits the market.
  • I am looking for a big correction to create a great opportunity to enter the stock for what could well become the preeminent ecosystem of them all.

Apple Q1 16A – The facts of life

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Apple’s slowdown is completely normal and priced in.

  • Apple reported steady Q1 16A results as the ending of the iPhone 6 replacement cycle is making it very difficult to grow revenues beyond their current levels.
  • Q1 16A revenues / EPS were $75.9bn / $3.28 pretty much in line with consensus at $76.6bn / $3.23.
  • 74.7m iPhones shipped, in line with consensus at 75m, and pricing increased to $691 which I think was largely responsible for gross margin and EPS being slightly better than forecast.
  • 16.1m iPads shipped which was below expectations and reflects the ongoing weakness of the tablet market which RFM forecasts will decline by 12% this year.
  • 5.3m Macs shipped which was below expectations but still represented market share gains in a continually weak PC market.
  • No volumes were given for Apple TV (where I think it is too early to say) or the Apple Watch (which I think is struggling with very weak demand).
  • Guidance for fiscal Q2 16E is for revenues of $50bn – $53bn which was below consensus of $55.5bn.
  • The revenue guidance midpoint represents a YoY decline of 7.5% of which 4.0% is due to the strength of the US$ against most other major currencies.
  • Given that Apple is coming off a year that saw a huge replacement cycle, keeping revenues broadly flat represents pretty good performance.
  • This was reflected in the shares which rallied slightly in after-hours trading as many commentators had expected much worse.
  • This fear was caused by suppliers, many of which, have seen meaningful cuts in orders from Apple.
  • I suspect that the difference between Apple’s performance and that of its suppliers is largely due to inventory adjustments as Apple right sizes its inventory for the slower outlook this year.
  • The good news is that Apple’s valuation remains incredibly undemanding with a headline 2016E PER of 10.5x which falls to 6.4x when Apple’s $216bn cash pile is taken into account.
  • This makes Apple one of the cheapest technology stocks available in the market and I think that the current slowdown is more than reflected in its valuation.
  • However, the shares are unlikely to race away again before a new avenue of growth is found and of this there is little sign.
  • Consequently, I think that Apple remains a great place to hide for anyone fearful of a volatile market but it is not the place to be when looking for upside.
  • I prefer Apple to Google, Yahoo and Twitter but there is more upside in the medium term to be found in Samsung, Facebook and Microsoft.

Twitter – Bloody hands

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Twitter could easily trade below $10 per share.

  • Everything is changing at Twitter except the one thing that really matters: its strategy. .
  • Part time CEO Jack Dorsey is cleaning house with 4 senior executives removed and the likelihood of 2 new board members to come.
  • Head of engineering, head of media partnerships, head of HR and head of product have all “chosen to leave” with existing execs picking up these roles on a temporary basis.
  • The net result is further uncertainty and the very real likelihood that any recovery is going to take longer than many are hoping.
  • Twitter is in a strategic bind.
  • Its service is extremely effective and very well monetised but it is such a small piece of Digital Life that its monetisation potential is fundamentally limited.
  • Furthermore, I think that its service is quite niche meaning that it appeals only to a subset of users which is why its user growth has also ground to a halt.
  • Shuffling management and reducing headcount should help improve profitability but they do nothing to return the company to top line growth.
  • I think that the answer to Twitter’s problems can be found in the Digital Life pie where Twitter has coverage of just 17%.
  • This is what I think must be addressed.
  • Twitter needs to encourage users to spend time beyond microblogging engaged with a Twitter service.
  • If successful, I suspect that this would stimulate user growth which combined with the increased Digital Life coverage would get revenues growing quickly once again.
  • The problem is that this requires a bold decision to be taken with regards to which Digital Life segment it should cover combined with heavy investments to bring it to fruition.
  • This necessitates a driven and focused CEO with a dedicated, talented and stable management team.
  • With constant turnover and a part-time CEO, I just can’t see how bold decisions are going to be taken meaning that Twitter will continue drifting.
  • With around 300m subscribers and 17% of Digital Life covered, I see Twitter generating revenues of around $2.1bn in 2016E.
  • This is significantly below Bloomberg consensus which is calling for revenues of $3.1bn this year.
  • Twitter currently has an enterprise value of $10.8bn ( it has $2bn in net cash) but compared to Google, it is still trading at a significant premium.
  • Assuming that consensus is right, Twitter is trading on 38.7x 2016E EV/EBIT while Google is trading on 16.0x EV/EBIT.
  • With growth having evaporated, I see no reason for Twitter to trade at a premium to Google and if I include my concerns with respect to consensus, there is still substantial scope for downside.
  • Twitter could easily trade below $10 per share and bargain hunters are likely to end up with bloody palms when trying to catch this falling knife.
  • Direction in strategy, a focused CEO and an end to management turnover are the minimum that is required to halt the slide.

Google – Blessing in disguise

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Trouble with Oracle gives the perfect excuse to abandon open source.

  • Vast revenues from Android should come as no surprise.
  • Google’s titanic 5 year struggle with Oracle took another twist at the end of last week with Oracle disclosing how much money it thinks Google has made from Android.
  • In justifying its claim for royalties, Oracle estimates that Google has generated revenues of $31bn with profits of $22bn since Android was launched in 2008.
  • There are two facts that indicate that these figures are not very wide of the mark:
    • First. Google has reacted with vigour to the disclosures and has attempted to prevent their publication.
    • Second. RFM’s own independent estimates of revenues from Google Android broadly support Oracle’s revenue estimate.
  • However, it is much less clear how much profit Google has made as it is impossible to split many of the costs of producing these revenues between fixed and mobile devices.
  • For example the costs of the developing the search algorithms, hosting the data and mapping data are independent of the device making them impossible to allocate to fixed or mobile.
  • This is why RFM only estimates revenues from mobile.
  • Any conclusions that Oracle has drawn with regards to profits from mobile are subject to the same caveats.
  • RFM estimates that between January 2013 and December 2015 (3 years) Google generated $20.4bn in advertising revenues from Android devices and $13.1bn in revenues from its app store: Google Play.
  • This gives a total of $33.5bn in revenues but profit could be anywhere from $10bn to $25bn depending on how the costs are allocated.
  • Although Android was launched in 2008, RFM thinks that the vast majority of revenues have been generated over the last three years as volume of Android devices really began to ramp up.
  • Consequently, I suspect that Google is going to have great difficulty in avoiding a hefty royalty payment to Oracle.
  • This will be expensive in the short-term but I think that it is a blessing in disguise.
  • I have long believed that in order to fix the problems of software distribution and endemic fragmentation, Google will have to take complete control of the software on its devices.
  • The problem is that taking open source software and making it proprietary will not go down well with the developer community or fit well with Google’s image.
  • However, with the viability of the system now clearly under attack from Oracle, then it has the perfect excuse to rewrite the entire run-time and remove the infringing code.
  • I think that the end result will be a complete proprietary operating system and ecosystem just like iOS and Windows 10 over which Google will have complete control.
  • This will allow Google to ensure that its user experience is as good as its competitors and to distribute its software updates in a timely fashion.

Galaxy s7 – More of same.

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S7 leaks highlight that Samsung remains all about volume.

  • The specifications of Samsung’s next flagship product appear to show that Samsung is taking very little risk with its handset business this year.
  • The Galaxy s7 will be launched in February and is expected to be made available in s7, s7 EDGE and EDGE+ variants mimicking exactly what has worked reasonably well in 2015.
  • 64GB Flash storage, 4GB RAM, 12MP rear camera and a 2560×1440 Super AMOLED display are the headline specifications.
  • US devices are expected to carry the Qualcomm Snapdragon 820 with ROW using Samsung’s own Exynos processor.
  • There is no mention of any new hardware to power some amazing new feature nor of any services.
  • Consequently, I expect that the outlook for the Galaxy s7 will be very similar to that of the iPhone 6s: more of same.
  • This is why I suspect that relative to 2015, Samsung is going to have a better year than Apple.
  • The iPhone is coming off a record year driven by faster than usual replacement sales while 2015 was year of stabilisation for Samsung.
  • This is likely to set the tone for the device market in 2016 where RFM forecasts just 3% growth in smartphone shipments and a 12% decline in tablet shipments.
  • When price declines are taken into account, it is extremely likely that the smartphone market will contract in revenue terms.
  • This means that competition will become even more intense underlining the critical importance of Samsung’s volume advantage.
  • Despite Huawei’s recent gains, Samsung still outsells its next nearest competitor by a factor of well over 2 to 1.
  • This is what gives it the ability to earn 9-11% handset operating margins while everyone else struggles along with 2-4% in the best instance.
  • I think that the sustainability of this premium depends almost entirely on its volume relative to its closest competitor rather than price.
  • This is what Samsung does best and I am comfortable that it should be able to hold this advantage despite 2016 being one of the most difficult years in smartphones for several years.
  • This combined with steady progress in the components business at excellent margins is what will return Samsung to some degree of growth in profits this year.
  • This is why I like Samsung.
  • Expectations and valuation are both low in contrast to Apple where much more is expected of the company going forward.
  • Microsoft, Samsung and Facebook remain the ones I most like at the moment.
  • I am fairly indifferent to Apple but cautious on Google, Twitter, Yahoo, BlackBerry and HTC.

Music streaming – The fault lines

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Spotify and Apple are the only two with a bright future.

  • Spotify has the smarts, Apple the default while Deezer manages to scrape together some cash.
  • Spotify has acquired two companies that when integrated into its service will continue to allow it to remain one step ahead of Apple when it comes to the user experience.
  • This is crucial because Apple Music has improved its user experience and is seeing meaningful traction in the market putting pressure on Spotify to stay ahead.
  • The two companies acquired are Soundwave, an app that beings in a social element to listening music, and Cord Project which is a voice messaging service.
  • These will be integrated into the Spotify which outside of finding and listening to music, comes up a little short when it comes to sharing and communicating with friends.
  • This builds on top of the developments that it has made in music discovery and deep learning that are aimed at ensuring that users are kept up to date with the latest tunes that are of interest to them.
  • Spotify has also been good at adding in services such as Running Mode where the music played adjusts to the user’s running cadence.
  • This kind of differentiation is crucial to keep Spotify ahead of its much larger and more powerful rival Apple.
  • The problem is that Spotify needs to spend more on marketing to tell non-users how great it is and of this there has been little sign.
  • At the same time, Apple has reached 10m subscribers and has done so in a tiny fraction of the time that it took Spotify to get there.
  • This is due to the power of Apple’s brand but mostly due to the fact that Apple Music is now installed on the devices of over 400m users.
  • This allows users to subscribe to the service with a touch of a button and nothing more.
  • By controlling the device, Apple makes its service the default option which historically has a massive impact on adoption.
  • The good news is that Spotify has so far been unaffected by Apple Music and remains the number 2 grossing app in the Apple App. Store.
  • This is despite the fact that Spotify is trying to get users to purchase their subscriptions elsewhere as the purchase on the Apple App. Store is 30% more expensive due to Apple’s revenue share.
  • The third player in this space is Deezer which has finally managed to raise some money following its failed IPO.
  • Deezer has raised $109m from a group of investors led by Len Blavatnik’s Access Industries which led a previous round of $100m in 2012.
  • I suspect that Deezer was about to run out of money and in return for this investment it has probably had to part with far more equity than was desirable.
  • The net result is that in music streaming there are two main players where I suspect that the market is big enough for both.
  • However, for everyone else the outlook looks very difficult and I see consolidation in this space before too long.

Flight to quality – Unicorns and donkeys part III

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The market is calling out the donkeys disguising themselves as unicorns.

  • The market has gotten off to a terrible start in 2016, but it is also taking no prisoners when it comes to separating the unicorns from the donkeys (see here and here).
  • Until recently, any company whose business is based upon the network economy could do no wrong and had easy access to capital through the private and public markets.
  • This was because there was an oversupply of positive sentiment and cash and a shortage of paper.
  • With the weakening growth in China and rising interest rates elsewhere, it is clear that quantitative easing is now over.
  • This, combined with a large increase in the number of companies in the networked economy all looking for capital, has played merry hell with valuations.
  • The result has been that only the well established players with hundreds of millions of users and fast revenue growth can still command high valuations.
  • This leaves the also rans (donkeys) struggling to raise money and the IPO window in the public market is slamming shut.
  • Furthermore, those companies that do not really have an ecosystem and are trying to sell hardware are also really struggling as the smartphone market is slowing to crawl with IoT and wearables yet to really emerge.
  • This is why GoPro, Under Armour, FitBit are all in free fall followed by would-be ecosystems and services like Twitter, Square, Box, Dropbox, Xiaomi. GrubHub and DoorDash.
  • In the meantime the true unicorns: Facebook, Uber, Airbnb, Linked-in, Amazon and Spotify are faring much better both in terms of fundamentals and in holding their valuations.
  • This is the classic flight to quality observed when the risk appetite of investors evaporates and I see no reason why thigs should improve in 2016.
  • I think that the key to being a unicorn is in becoming to the “go-to” place for a service as it is then that real monetisation can begin.
  • The rule of thumb that I apply here is:
  • A company that relies on the network must have at least 60% market share or be at least double the size of its nearest rivals to begin really making profit.
  • Once this has been achieved, then there are real fundamentals to a business which is then in a much better position to survive when the going gets tough.
  • Everyone else including those that are trying to monetise hardware without an ecosystem, are going to have a very difficult time this year.
  • I do not want to back any company that does not either have a thriving ecosystem or a commanding position in the market that it serves.

 

Facebook & WhatsApp – JK come home

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WhatsApp will have to be integrated to earn a good return.

  • Facebook has finally admitted that subscription is not the way forward for WhatsApp but I suspect that enterprise is merely a stop gap.
  • WhatsApp founder, Jan Koum has officially dropped the subscription fee of $0.99 and stated that the company is leaning towards the enterprise as a method of monetisation.
  • Many companies connect with their customers via SMS messaging and WhatsApp is proposing that these companies may be prepared to pay to do that using WhatsApp.
  • Facebook has always said that it would not really worry about monetisation of its assets until they hit 1bn users and I suspect that WhatsApp is getting very close to this number.
  • Jan Koum may be able to get enterprises to pay something to use WhatsApp as a channel to reach their customers but I very much doubt he will ever be able to make enough to justify the US$22bn that Facebook paid for the company.
  • This is because WhatsApp is still adamant that it will continue to operate independently from Facebook.
  • I think that this was part of the deal when Facebook acquired WhatsApp but I remain convinced that the real value from WhatsApp will only be released by putting the two together.
  • RFM research indicates that when considering a series of Digital Life services (like Facebook) there is far more value to be gained if these services are integrated.
  • This is because the ecosystem can then learn what its users do across a range of activities rather than just one.
  • If the services are not integrated then the ecosystem only learns about individual users within a single service and cannot connect the dots when a user spends time with multiple services from that ecosystem.
  • The value of understanding what the does across services A, B and C is completely missed and it is here where I think the real upside is.
  • Consequently, I think that for as long as WhatsApp remains independent and not integrated into the Facebook family, it will never create enough value to justify its acquisition price.
  • I see signs of Facebook taking Messenger into gaming like LINE and KakaoTalk and I suspect that the same will eventually be true for WhatsApp.
  • The transition from single services to a fully-fledged ecosystem is likely to take a long time because when Facebook is assessed on the quality of its ecosystem, it becomes clear that there is a vast amount of work to do.
  • For Facebook to really grow revenues in the long-term, its ecosystem needs to be firing on all cylinders and I don’t think this is going to happen before its current set up runs out of steam.
  • Consequently, I think that Facebook could see a pause in growth in H2 2016 which is likely to result in a heavy correction in the shares.
  • It is at that time that I would be looking to enter Facebook for the long-term upside.

Google Auto – Greek gift

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Automakers should be wary of Google’s autonomous gift.

  • The most significant event at the Detroit Auto show this week was the offer from Google to the car makers of an easy route to autonomous vehicles.
  • Following on from its rumoured venture with Ford, Google is actively seeking partners in the automotive industry to deploy its autonomous driving technology.
  • Although the auto makers are all working on creating this technology in house, I do not see them having the expertise, processes or the experience to come up with a viable solution in the medium term.
  • By contrast Google has the map and the essential deep learning technology to bring this technology to market within a reasonable time frame.
  • Furthermore, of all the solutions that are currently being developed, I think that Google’s is by far the most advanced and is likely to be first to hit the market.
  • Google also has vast resources to invest in this meaning that it can ensure that it works a perfectly from launch.
  • Auto makers are in a difficult position as they are still struggling with the concepts of software and consequently are very far behind in understanding what is happening to their industry.
  • Consequently, when Google shows up with what looks like the answer to many of their problems, it is difficult to resist but resist they must.
  • There are two reasons for this:
    • First. Although everyone is targeting 2020 for the technology to be ready, I do not expect that the regulatory and legal framework to be in place much before 2030 (see here).
    • This means that time to market is actually not that important which gives the automakers much more time to hire or acquire the right talent to build their own autonomous solutions.
    • Second. I see this as a Trojan horse for Google to disrupt the automotive industry and turn automakers from brands into Android handsets on wheels.
    • At the beginning, autonomous vehicles will only be a fraction of the market but they are almost certain to become the mainstream in the long-term.
    • Consequently, allowing Google into the vehicle, even just for autonomous vehicles is very dangerous for the long-term outlook for any car maker.
  • Google’s aim in life is categorise all internet traffic and make money by selling targeting advertising based on what it learns.
  • It already does this to great effect on the PC, phone and tablet and the auto is just another device from which Google hopes to collect data.
  • If it can commoditise the car market, then cars will become much cheaper meaning greater penetration of vehicles, more journeys made and more data collected by Google.
  • It has already done this to great effect in Android devices and here, it has managed to take the vast majority of the profit pool for itself.
  • I think that it aims to replicate this strategy in the automobile meaning that car makers need to treat its advances with great caution.
  • With even the growth of smartphone users beginning to slow, Google needs to look to other avenues to find high growth in the long-term.
  • This is where its interests in the smart home, health and the automobile are all coming from.
  • Automakers need to ensure that it is they that have the relationship with the user and not Apple, Google or anyone else.
  • They days of forgetting about the car when it leaves the showroom are over and the future of the auto industry depends on them realising and acting on that fact.
  • I think that they have more time to act then the tech industry thinks, but failure will not be pretty.