Amazon / Baidu Results – Away from home.

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Both companies being driven by new businesses.

Amazon Q1 16A. 

  • Amazon reported mighty results as Amazon Web Services (AWS) grew by 64% YoY and contributed 55% of group EBIT despite only contributing 9% of total sales.
  • Q1 16A revenues / EBIT / EPS were $29.1bn / $1.07bn / $1.07 compared to consensus at $28.0bn / $584 / $0.59.
  • Although North America remained nicely in the black, the star of the show was AWS which generated $604m of EBIT accounting for almost all of the better-than-forecasted performance.
  • This strength also underpinned guidance where Q2 16A revenues / EBIT are forecasted to be $28.0bn – $30.5bn (midpoint $29.25bn) / $375m – $975m (midpoint $675m) compared to consensus at $28.4bn / $878m.
  • Despite being the largest cloud provider, AWS gained share during the quarter and is increasingly looking unassailable.
  • Its huge scale gives it the ability to offer global points of presence which meaningfully improves performance for global companies and it can offer this with lower costs.
  • Furthermore, the underlying AWS software upon which companies build their IT operations is unique to Amazon, making switching an increasingly difficult and painful process.
  • Hence, I think AWS will remain strong which combined with the steady progress in retail keeps the overall growth outlook good.
  • However, the same cannot be said for the valuation.
  • Even including an EPS upgrade to $6.00 for this year and $10.00 for 2017 leaves the company trading on 113x 2016E PER and 68x 2017E which is way too rich for my blood.
  • Amazon’s valuation has been discounting future profits for years and now that they have arrived, it is time for the multiple to begin returning to normal levels.

Baidu Q1 16A. 

  • Baidu reported results that met expectations as profits from its dominant position in search continued to be ploughed into O2O and online video investments.
  • Q1 16A revenues / EPS were RMB15.87bn ($2.4bn) / RMB2.2bn ($340m) almost exactly in line with consensus at RMB15.82 / RMB2.2bn.
  • Mobile now makes up 60% of revenues with Baidu’s ecosystem reaching 663m users meaning that 89.1% of Chinese mobile users are actively using its services.
  • However, this looks like a slight loss of market share as in Q4 15A, RFM estimates that Baidu’s ecosystem reached 89.8% of China’s smartphone users implying that Qihoo and Sohu have gained slightly in Q1 16A.
  • Despite this, search remains hugely profitable but much of this is being ploughed into new businesses
  • This becomes apparent when one separates search from the O2O (online to offline) and online video businesses.
  • Group adjusted operating margins were 15.4% but if losses from O2O and online video are removed, search margins are revealed at 49.8%.
  • Between them, these two businesses have racked up RMB5.7bn in losses in one quarter alone making them a very big bet as far as investors are concerned.
  • Fortunately, the outlook for growth in 2016 is reasonably good meaning that search is likely to keep delivering cash for investment.
  • Whether Baidu can deliver returns on these investments remains to be seen but comments on the call such as “we will worry about the business model later” do not inspire confidence.
  • Baidu has a stranglehold on the Chinese search market very much like Google does in the rest of the world.
  • However, it is there that the similarity ends as Google clearly understands the ecosystem and Baidu does not even though it has reasonably good coverage of the Digital Life Pie.
  • Consequently, everything depends on Baidu being successful with Nuomi, its platform for e-commerce and O2O services.
  • Here its GMV of RMB16bn is just a fraction of Alibaba’s at RMB964bn meaning that it has to do something very special to prevent itself from being squeezed by its much larger and more powerful rival in e-commerce and O2O.
  • Baidu is likely to remain volatile while its develops it services beyond search.

Facebook Q1 16A – Painful splits.

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A stick in the eye for corporate governance.  

  • A great set of results was marred by the timely announcement of a share split that further strengthens the founders’ grip on the company to the detriment of all other owners.
  • Q1 16A revenues / adj-EPS were $5.4bn / $0.77 compared to consensus at $5.3bn / $0.62.
  • Although revenues beat by 2.5%, EPS beat by 23% mostly due to a lower tax rate but also due to expenses growing more slowly than revenues.
  • The outlook for profit and cash flow has also improved as the company stated it should be able to keep expenses within the current plan despite revenues faring better than expected.
  • With 1.65bn MaU’s and 1bn daily users on mobile devices, Facebook still has all the makings of the biggest ecosystem of them all.
  • The good news is that the company has recognised this (see here) and is moving full steam ahead to make the most of the opportunity that it has.
  • The combination of this opportunity and the superb execution of Sheryl Sandberg’s organisation keeps me confident that there is much more to come from this company.
  • However there are few bumps that need to be navigated first.
    • Firstly, I still see problems in the second half of this year.
    • This is because RFM’s research indicates that market expectations in H2 2016 are significantly ahead of what RFM thinks is possible given Facebook’s current level of development.
    • In essence, I think that the market is assuming that revenues will begin to flow from the new strategies before these plans are mature enough to begin generating revenues.
    • The result is likely to be a miss in Q3 16E or Q4 16E that will send the shares into a tail spin.
    • It is at that point that I would be looking to enter for the long term.
    • Secondly, many of Facebook’s new strategies to keep users within its ecosystem require artificial intelligence and machine learning.
    • I think that this is Facebook’s Achilles heel as this is not in the company’s DNA unlike Google.
    • Early interactions with Facebook M and the bots that have been launched (see here) show machines that are far too stupid to be of any real use.
    • If I was a company looking to build a bot to interact with my customers, I would not be using Facebook’s.
    • I would instead be looking at Google or Microsoft as a foundation for my machine intelligence.
    • This is a real problem as unless fixed, it will drive traffic away from Facebook properties and into the arms of its rivals.
    • Traffic is the life blood of Facebook upon which all future revenue growth depends.
  • I am reasonably confident that Facebook has recognised its weaknesses as it has been quick to grasp the importance of the ecosystem concept and so I hope the AI problem will also be fixed.
  • However, the biggest problem is the share split.
  • Just like Alphabet did before it, Facebook is creating a new class of share that has no votes attached to it at all.
  • Two class C shares will be created for every A and B share and will be distributed as a one-time dividend to existing shareholders.
  • This will ensure that the founders’ control of the company will remain unchanged as control and economic interest will become even more divorced than they are today.
  • For small, early stage companies a super voting structure makes sense as speed and decisiveness are needed but I firmly believe that this has no place in large public corporations.
  • I find that the arguments for perpetuating this unfair structure have no merit and I fear that corporate governance has taken a turn for the worse.
  • When this type of structure persists, no one minds until things start to go wrong.
  • When problems arise, founders tend to be more emotionally attached to losing strategies than professional managers.
  • Because no one can force them out or to change, they tend to stick with these losers far longer than they should.
  • The result is that problems tend to be far worse and last much longer than they otherwise would if the shareholders had the power to enact change.
  • The example of Ericsson’s emergency rights issue in 2002 is a great example of how bad things can get with these types of shareholding structures.
  • While Facebook continues to beat expectations no one will care, but from a long term perspective any rational investor should put a discount on his fair value to account for this shortcoming.
  • I place a 30% corporate discount on my estimate for Alphabet, and I see no reason why I should not do the same for Facebook.

Apple / Twitter Results – Show me the money.

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Cash flow is king when growth deserts.

 Apple FQ3 16A. 

  • Apple reported difficult FQ2 results but critically, iPhone shipments fell by far less than many had feared, confirming my view that this is the end of a cycle not a secular decline.
  • FQ2 16A revenues and EPS were $50.6bn / $1.90 missing consensus of $52.0bn / $2.00.
  • iPhone shipments were 51.2m compared to consensus of 51.0m with ASPs of $642 compared to $670 in FQ1 16A.
  • A large part of the ASP weakness can be attributed to the strength of the USD which impacted overall revenues by 4% during the quarter.
  • iPad shipments were 10.3m slightly better than expected driven by the larger screen iPad Pro.
  • Mac shipments were 4m slightly missing expectations as the weakness in the PC market has finally impacted demand for Macs.
  • Guidance was also disappointing with FQ3 16E revenues and gross margins expected at $41bn – $43bn / 37.5%-38.0% missing consensus at $47.6bn / 39.2%.
  • Apple explained the shortfall as a $2bn inventory adjustment to reflect a more cautious outlook, the impact of the lower iPhone SE ASPs and the weaker outlook for the PC market.
  • However, I continue to believe that the issue that Apple faces is simply that the iPhone 6 product cycle has come to an end.
  • The iPhone 6 addressed a new segment of the market for the first time and also addressed the biggest complaint of iPhone owners namely the small screen.
  • Consequently, there was a lot of pent up demand for the device and many users also switched from Android to iOS.
  • This phenomenon is now over and iPhone demand has normalised leaving Apple looking at declines in revenues while its performance is being compared to periods when the cycle was in full swing.
  • What concerns me more is gross margins which will suffer in the coming quarter from the lower revenue base and a weaker product mix.
  • I highlight gross margins as they are the precursor to cash flow, and with a company that is not growing, cash flow is of paramount importance.
  • Apple has $232bn of gross cash meaning that the enterprise value of the company is $372bn (taking into account after hours trading and $70bn of debt).
  • This quarter Apple generated free cash flow of $33bn which taking into account the lower guidance, the slowing market and capex should comfortably come in at $120bn over the next 12 months.
  • This is a free cash flow yield of 32% to anyone holding the equity today and Apple is clearly moving to return more cash to shareholders.
  • With this level of return, I think growth is irrelevant but profitability must remain very strong for this thesis to work.
  • I see no real immediate threat to Apple’s profitability and on the basis of cash flow yield, the shares are extremely attractive.

Twitter Q1 16A. 

  • Twitter reported bad results as the fundamentals of the company performed more in line with RFM forecasts than the overly optimistic market.
  • Q1 16A revenues / adj-EPS were $595m / $0.15 compared to consensus at $608 / $0.10 and RFM at $573m.
  • User numbers managed to pick up a little coming in at 310m compared to consensus at 308m but guidance was very weak.
  • Q2 16E revenues are expected to be $590m-$610m compared to consensus at $678m and RFM at $576m.
  • The culprit was lower demand than expected from branded advertisers, underlining my long held concern that advertisers do not want to spend more on Twitter because its focus remains too narrow.
  • Twitter only covers 17% of the Digital Life Pie meaning that users spend the vast majority of their time on devices doing something that is outside of services that Twitter offers.
  • This fundamentally limits Twitter’s attraction to advertisers which combined with its flat-lining user growth is why revenues are grinding to a halt.
  • To turn this around, Twitter needs to find something to encourage to users to spend more time within its properties and break out of being a news broadcaster.
  • If successfully executed, I think this would have the effect of restarting user growth and reigniting advertiser interest which would unlock a period of very rapid, catch-up growth.
  • Unfortunately, this requires focused and highly engaged management team which I believe is impossible with a part time CEO.
  • Until this is rectified, I think the company will languish with very little or no growth.
  • Twitter does not have fantastic cash flow to support its valuation.
  • In the last 3 months generated a fairly meagre $103m in free cash flow translating into a yield of just 1% compared to Apple at 32%.
  • This why I think Twitter could test $10 per share as the reality of its lack of growth sinks in there is no real cash flow to backstop the valuation of the equity.

Apple Auto – Titanic task

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Like the television, I think the car will never launch.  

  • While I am sure that Apple is engaged in building an autonomous automobile, I think that it is finding it much harder than expected and I still do not expect it to ever launch.
  • I think that this is similar to the large screen television that Apple built but never launched albeit on a larger scale.
  • The issues I have with Apple becoming a car maker are simply that making these sorts of products is not something that Apple really knows anything about nor is the market or regulation of cars like anything else in which Apple is currently active.
  • This is why I think Apple turned to BMW and Daimler for their experience and expertise in building these sorts of high quality products.
  • However, both of these companies have realised how important the data the vehicle generates is and consequently refused to allow Apple to store it in iCloud.
  • The net result appears to be that Apple has turned instead to one of the tier 1 suppliers as these companies are much less likely to have these sorts of objections.
  • Apple partnering with a member of the automotive industry does not alleviate the most pressing problem with Apple selling a car which I think remains profitability.
  • Apple prides itself on earning 40% gross margins on the products that it sells and unless it can earn 40% gross margins on wheels, brakes and sheet metal, an automobile will be significantly margin dilutive.
  • I think that this would be catastrophic for the valuation of the company as a main pillar of Apple’s valuation is its fantastic profitability.
  • Many car companies make no money at all on the products that they sell but instead earn a return on the financing that they provide to make it easier for consumers to buy their products.
  • Against this backdrop, 40% gross margins on a car, even one with an Apple badge on it, look hopelessly unobtainable.
  • It is clear that the automobile will become an important device in the digital ecosystem where users live their digital lives making it an area that Apple cannot ignore.
  • Consequently, Apple needs to understand the automobile industry and its users and the best way to do that is to get one’s hands dirty and build one.
  • From an economic standpoint, it still makes most sense for Apple to make an infotainment unit (see here) but all of the car makers have realised the strategic importance of the infotainment unit to their brands long term.
  • Hence, none of them are about to leave a hole in the console for Apple to fit its unit, earn 40% gross margins and suck out all of their data.
  • As a result, I think that Apple’s future in the automotive market is very uncertain as both avenues of earning a return through selling hardware look like dead ends.
  • I think that project Titan is designed to teach Apple what it needs to know about the automotive industry so that it is in a position to make the most of whatever opportunity appears in the future.
  • This could be services, a companion device, an autonomous driving system or even a partnership but I still think it extremely unlikely that there will ever be an iCar.
  • Apple remains very lowly valued but its lack of growth is likely to hamper appreciation in the share price.
  • Apple looks good for long term holders but those looking for share price appreciation in 2016 would do better to look at Microsoft or Samsung.

Amazon – Proper practitioner?

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Signs of progress at last.

  • Amazon is finally showing some early signs that it is beginning to understand the value that creating an ecosystem could bring to its bottom line.
  • Amazon’s has made some changes to its Amazon Prime as well as to its Twitch website which point to expanding coverage of Digital Life as well as understanding the importance of user numbers.
  • These changes are:
    • First. Amazon has added some new service levels to Amazon Prime.
    • In addition to the $99 per year tariff, there is now a $10.99 monthly that can be cancelled with one month’s notice and an $8.99 video only tariff.
    • This brings Amazon more into line with Netflix and Hulu but I hope that there is more to this tariff than just meeting these two.
    • Second. Amazon’s gaming video website, Twitch, is moving away from being just a place to upload video like YouTube and becoming more like a social network.
    • Twitch already had the facility for private messaging but with its new friend function, it is beginning to look more like Facebook than YouTube.
  • These changes could start to meaningfully improve the appeal of Amazon to users who are not hard-core gamers or shoppers but there is still a very long way to go.
  • To date RFM has been of the opinion that Amazon has not had any real understanding of the ecosystem as it was making no real effort to make its ecosystem larger.
  • RFM research indicates that 100m users are needed for an ecosystem to hit critical mass but 300m are needed for real money to be made.
  • I think that any ecosystem that Amazon creates will be based upon Amazon Prime and to date, I believe that the requirement to take the free shipping option has been a hindrance to take-up.
  • Consequently, Amazon still has less than 50m users which I think needs to be massively expanded for Amazon to make the most of the digital assets that it has assembled.
  • A lower price point to enter the ecosystem is required as well as greater coverage of Digital Life and much greater cohesion between the assets and services that it owns.
  • The new Amazon Prime tariff is a step in the right direction but it needs to become even cheaper, or even free, for Amazon to really see the take up it needs.
  • I not about to forecast that Amazon will now become a thriving and vibrant ecosystem but importantly there are now signs that Amazon has understood what is required and that more changes and upgrades are to come.
  • I would also like to see Amazon integrate all of its properties together such that it can really understand its users as well as offer a more seamless and delightful user experience.
  • That combined with a much lower barrier to entry is what will drive user uptake and turn Amazon from a dabbler into a proper practitioner.
  • I continue to struggle with Amazon’s valuation as owners are already paying for profits which are not being made.
  • Consequently, I still prefer Samsung, Microsoft, Apple or even Alphabet compared to Amazon.

MSFT Q3 & GOOG Q1 – Two more strikes.

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Microsoft and Alphabet compound Ericsson’s and Intel’s woes

Microsoft FYQ3 16A

  • Microsoft reported reasonable results as the weakness in the PC market did not hurt the company as much as Intel’s troubles lead me to fear.
  • FYQ3 16A revenues / adj-EPS were $22.1bn / $0.62 compared to consensus at $22.1bn / $0.64 and RFM at $20.3bn / $0.52.
  • The continued shift towards cloud based businesses is putting some pressure on gross margin but also increasing the tax rate which was largely responsible for the EPS miss reported.
  • Growth has continued in all of the really important areas (cloud and Office 365) and Microsoft has done well to mitigate the impact of weakness in the PC market.
  • Phones continued their tail-spin leaving the question with regards to what Microsoft will do with its consumer ecosystem wide open. (see here).
  • Guidance for FYQ4 was also a little soft with revenues forecast at $21.7bn – $22.4bn compared to consensus at $23.1bn (4.5% miss) and RFM at $21.9bn.
  • PC weakness and very slight softness in the cloud is being blamed for the small undershoot, but frankly I don’t put too much weight on single quarters.
  • The net result is a small reset in expectations that in reality does not change the long term outlook.
  • Here Microsoft remains a dominant force in Digital Work and that alone is enough to justify holding the shares.
  • The free option that is the consumer ecosystem remains a huge question mark which I hope will soon be addressed.
  • I still see value in Microsoft and with the market selling off to the low $50’s, it just became more interesting.

Alphabet Q1 16A

  • Google reported weaker than expected results as traffic from sites and devices not under its control grew faster than its owned properties.
  • Q1 16A revenues-Ex TAC / adj-EPS were $16.47bn / $7.50 compared to consensus at $16.56bn / $7.96 and RFM at $16.12bn / $7.69.
  • Alphabet explained away this weakness by stating that profits had suffered as a result of mobile’s growth and the higher Traffic Acquisition Costs (TAC) that are associated with it.
  • I think that this is not a very good explanation as growth in mobile has been going on for some considerable time and this has never been a problem before.
  • Hence, I suspect that the reality here is that the last few quarters have been driven by the increase in market share of iOS where Google generates far higher revenues than it does on Android.
  • The end of the iPhone 6 product cycle means that Android devices are once again growing their share in the Google ecosystem and here I think that Google has lower gross margins.
  • I think that these lower gross margins are driven by the costs of developing and maintaining the Android OS as well as the nature of the revenue sharing agreements compared to its deal with Apple.
  • These agreements often have a cap and it is likely that the iOS cap has already been surpassed.
  • This combined with the slowing outlook for mobile devices and ecosystem user growth in general means that the Google business will slow in the medium term.
  • This is something that is not unexpected but for a market that struggles to see past the next three months, it is comes as a surprise.
  • In light of the slower outlook, Google is taking action and I see the rationalisation of its investments in Other Bets as well as the fact that G&A expenses fell to 7.5% of sales in Q1 16A as a good sign for fiscal discipline.
  • Alphabet is becoming a mature company which combined with its recent rally makes me pretty indifferent to the shares.
  • I am also indifferent to Apple but there are far fewer risks to the outlook at this time making this a better place to hide.

Alphabet – In the soup.

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The EU kicks off a lengthy war with Google over Android.

  • Google has been formally accused by the EU of abusing its dominant position in Android to the detriment of its competitors and EU based users in general.
  • The accusation takes the form of a Statement of Objections following an initial investigation but is not in any way a final judgement of guilt.
  • That finding comes later (potentially years) once the commission has deepened its investigation and Google has had an opportunity to respond to the allegations as well as take remedial action.
  • The complaint that has been made is very similar to the one made against Microsoft which managed to kill off browser competition by bundling Internet Explorer in with its Windows OS on PCs.
  • This time around, Google is being accused of obstructing competition for Google Play and its Digital Life services by effectively forcing handset makers to put its services front and centre on its devices in order to get access to Google Play.
  • It is alleged that it does so in three ways.
    • First: The Mobile Application Distribution Agreement (MADA).
    • This agreement requires anyone wanting to use Google Play to also include the key Google services such as search, mail and maps and to display them prominently in a folder on the home screen.
    • RFM research indicates that it also requires these services to be default on the device such that a request from an app to open a map always defaults to Google Maps.
    • This ensures that it is Google’s Digital Life services that are predominantly used and it is this bundling that the EU objects to
    • Google will truthfully argue that no manufacturer is forced to sign the MADA, but the reality is that it is almost impossible to sell an Android device in the EU without Google Play installed.
    • Google will also correctly argue that users can install other app stores after purchase, but this is not easily done and without doubt it will make the bad security situation much worse.
    • Second: The Anti-Fragmentation Agreement (AFA).
    • This agreement is required for a handset maker to deploy Google Play and prevents the manufacturer from producing other devices that use non-Google versions of Android.
    • This prevents any handset maker from providing any alternative to Google on any Android device anywhere in the world.
    • I suspect that this has been a factor in Google’s ability to dominate the Indian market where it is now almost impossible to sell a device without Google Play on it.
    • Google has effectively seeded the Indian market with its services and the game may already be over for the home grown alternatives.
    • The EU’s concern here is that Google has prevented competition and stifled innovation through the use of the AFA.
    • Third: Payment of Traffic Acquisition Cost (TAC).
    • Google pays the handset makers for the traffic that is generated for its services but only if the Google Services are pre-installed and no competing services are preinstalled.
    • Pre-installation ensures that the service or app will function optimally and can be set as default.
    • As I have argued before, being set as default is an extremely powerful way to ensure that almost all users will use one’s service even if it is inferior (see here).
    • The EU’s concern is not with the payments per se, but with the fact that TAC is not paid if competition services such as search are also pre-installed on the device.
  • The good news for Google’s competitors is that the EU has accepted that Google has a dominant position in search, smartphone operating systems and Android app stores.
  • This has been of concern to me because the EU’s definition of dominance requires 70% market share and it is not difficult to argue that Google’s position falls below this threshold even in the EU.
  • However, the EU complaint against Microsoft was simple compared to this multi-faceted and complex situation that exists in Android devices.
  • I fully expect that Google will vigorously defend its position and I suspect that it has a much better chance of winning than Microsoft did.
  • This case also has far reaching and global implications because I am pretty sure that if Google ends up being forced to relax the AFA and MADA requirements for the EU, then the rest of the world will quickly follow.
  • This is mainly because the AFA is a global agreement and if it is relaxed then handset makers will be free to make and sell devices with competition ecosystems in other parts of the world.
  • However, time is on Google’s side as the longer this battle takes, the more time it will have had to build loyalty to its store and services with users.
  • Once that loyalty has been established, users will be inclined to use Google services, even if there are alternatives easily available.
  • On the other hand, RFM research indicates that the Amazon App Store is almost as good as Google Play and I believe that there is scope for high quality alternatives assuming a level playing field.
  • Internet Explorer’s steady market share loss on Windows PCs is a good example of how it is not always impossible to overturn a hugely dominant position with a good quality alternative.

Yahoo and Intel Q1 16A – Falls at the first.

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Results season off to a tough start

Intel Q1 16A

  • Intel reported a difficult set of results and cut 10% of its workforce as the server business can no longer compensate for the damage being done by the weakness in PCs.
  • Q1 16A revenues / EPS were $13.7bn / $0.42 broadly in line with forecasts of $13.8bn / $0.37 but the outlook was weak.
  • Q2 16E revenues are expected to be around $13.5bn with gross margins around 61% which compared unfavourably with consensus at $14.2bn / 62%.
  • The problem remains the PC market which fell nearly 10% in Q1 16A as content consumers continue to desert the platform.
  • I still think that the PC market will stabilise once all these users have left, but it is taking longer than I originally anticipated.
  • With the data centre business beginning to slow down, Intel has to look elsewhere to make up the difference.
  • Here, it will be mobile, Internet of Things, Wearables, automotive and so on where Intel will be looking but this is easier said than done.
  • Intel has been struggling in mobile for 15 years despite vast investments and the ARM processor remains a much better proposition for many of the segments that Intel is hoping to address.
  • The job reductions are clearly aimed at realigning Intel to the new reality it faces as well as preserving its superb profitability until the other business lines can be brought up to speed.
  • With Intel’s history outside of its core markets, this will be a big ask and with ARM finally having a credible go at the server market, the immediate term outlook remains very difficult.

Yahoo! Q1 16A

  • Yahoo reported results that just beat the very low expectations set by management but underneath the veneer, I see declining engagement in mobile.
  • Q1 16A revenues-ex TAC / Adj-EPS were $859m / $0.08 compared to forecasts of $847m / $0.08 but guidance for Q2 16E missed again.
  • Q2 16E revenues are expected to be $810m-$850m ($830m midpoint) compared to consensus at $860m.
  • Yahoo is now struggling with video advertising which is one area where all of its peers are seeing strong growth highlighting again how bad the execution has become at Yahoo.
  • Furthermore, I see weakness in mobile.
  • Yahoo generated $250m in revenues from mobile devices but benchmarked (see here) on its already dismal performance in mobile in Q4 15A, I was expecting $270m in Q1 16A.
  • In Q4 15A, RFM calculated that Yahoo managed to monetise 12% of the opportunity that it has in mobile which fell to 11% in Q1 16A.
  • Yahoo refused to be drawn on any aspect of the sale process which I think is likely to end with Yahoo selling its core assets at a very low price.
  • This is likely to be positive for the share price as the core value of Alibaba and Yahoo Japan should be unlocked when the assets are separated.
  • However, given the increasing problems that Yahoo has in both mobile and video, I see risks to FY 16E guidance of $3.4bn-$3.6bn which will be high in the minds of all potential acquirers of the core business.
  • There is huge value in Yahoo shares but it still looks like a value trap as these results indicate that things are getting worse not better.


Apple App Store – Coup d’état.

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A meritocracy becomes a plutocracy.

  • The anticipated changes to the Apple App. Store will no longer mean that the apps most liked by users will rule the roost and it may also do some damage to the instant messaging platforms.
  • It looks like Apple is going to overhaul the user experience in terms of how users discover apps in the Apple App Store and at the same time add a new revenue stream.
  • This is long overdue as the app store has remained untouched for a very long time.
  • With 2.28m apps in the store, finding what one wants has become much more difficult for users.
  • It also causes real problems for the smaller developers as very often their apps sink without trace regardless of how good they are.
  • When the app store was in its infancy this was not a problem and the three main charts combined with categories and editor’s picks was enough.
  • However, apps are now a multi-billion dollar business and the app store so big that more sophisticated discovery is needed such that users are able to discover apps and services that they are willing to pay for.
  • I am pretty certain that better discovery will lead to an uplift in the amount of money that users spend on a monthly basis.
  • This is why I suspect that Apple has been hard at work making changes to how apps are discovered and may even be about to add a paid search function.
  • This would allow app developers to have their apps feature at the top of search results in a vein similar to Google.
  • However, I think that this will make life even harder for the smaller developers who can’t afford to pay to have their apps positioned more prominently.
  • This is why the search function and Apple’s understanding of its users will be very important.
  • Very much like TV, there are a few apps that everyone uses and then a very long tail of special interest apps that appeal to specific types of users.
  • It is this that Apple has to get a handle on and ensure that its AI and search algorithms are good enough such that the right apps are discovered by the right users.
  • I expect to see some progress on this at Apple’s developer conference (WWDC) in June.
  • I also think that a big improvement in app discovery will cause some problems for the instant messaging players.
  • Instant messaging is hugely popular but incredibly difficult to monetise which is why many of the suppliers have started to evolve their IM platforms to do other things.
  • Part of the reason for their success in encouraging third parties to develop within their IM platforms has been the difficulty in app discovery on the much larger Apple App Store and Google Play.
  • Consequently, if discovery becomes much easier on the Apple App Store, developers’ inclination to develop elsewhere is likely to decline.
  • However, the major instant messaging platforms are now so big that they should be able to offer developers a decent return.
  • Hence, it looks like Apple’s opportunity to quash this off-shoot of third party app development has passed.
  • The net result of these changes is likely to be that the biggest and the strongest app developers will have even more influence over what users download and pay for.
  • These developers also have the marketing budgets to advertise through the traditional channels as well as online which will make like even harder for the smaller developer.
  • Consequently, I hope that the other changes that Apple makes to the App Store will help level the playing field as it is often the smaller developers that come up with the novel and innovative ways to use the smartphone that drive the industry forward.
  • Apple remains beset with fears of falling orders and low growth and against that backdrop it is hard to see the shares rallying.
  • However, the shares are so lowly valued that those happy to sit and hold for the very long term are very unlikely to do badly.

Facebook F8 – Cash crusade.

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Where the connection crusade goes, the cash machine will follow.

  • Facebook made it very clear at its developer conference that it will stop at nothing to ensure that everyone is able to share anything with anyone.
  • The net result of more connections, more sharing and more time spent with Facebook, will be a substantial increase in the revenue opportunity but of this, there was no mention.
  • To date, Facebook has been ruthlessly efficient at making the most of its revenue opportunity and, with Sheryl Sandberg running the cash machine, I am confident that this will continue.
  • RFM estimates that Facebook’s opportunity is currently around $24bn in annual revenues but if its strategies are successful, this should grow to more than $40bn.

At its developer conference Facebook did 3 things:

First: Demonstrated ecosystem understanding.

  • In laying out the 10 year roadmap, Facebook clearly demonstrated that it has understood and embraced the importance of the ecosystem.
  • Today, Facebook is effectively a two trick pony with social networking and instant messaging.
  • All of its announcements from messaging bots to open source infrastructure and are squarely aimed at driving traffic to its servers.
  • It has also realised that there is an exponential relationship between how much time users spend in within its servers and how much value it can derive from it.
  • I think that the lack of integration between Messenger and WhatsApp is still a major problem because without it, Facebook is unlikely to really be able to monetise WhatsApp to its fullest extent.
  • In addition to clearly moving to increase its coverage of the Digital Life pie, Facebook is also building all of the software infrastructure that is needed for its services to run completely independently.
  • For emerging markets this is very important as Google is rapidly becoming its No.1 competitor and currently, most of Facebook’s apps are dependent on Google system services.
  • Facebook cannot possibly keep this dependency and still expect to be able to maximise its opportunity in emerging markets.

Second: Declared war on hardware.

  • Facebook clearly sees the cost of hardware as a hindrance in both bringing a large part of the 4.1bn offline people online for the first time and in driving usage.
  • Consequently, it is on a mission to bring the cost of hardware down such that its services become accessible to many more users.
  • This is why it has announced products in telco infrastructure, last mile access and a professional grade, high resolution 360 camera that shoots 3D at 60 frames per second with 8K to each eye.
  • However, Facebook does not intend to make any of these products but instead will be open sourcing the designs and the software for anyone who wants them.
  • Even if these products never make it to market, it will give telecom operators and content creators leverage when it comes to price negotiations.
  • Facebook is hoping that some of these savings will be passed onto users in the form of lower tariffs, enabling more to get online with the result of more traffic arriving at its servers.
  • Facebook has no need to do this in smartphones as Google and the Chinese have already done its work for it.
  • The net result will be gross margin pressure for the traditional hardware vendors, as from Facebook’s perspective, it makes long term business sense to give away what hardware companies view as their most closely guarded secrets.
  • I suspect that the Oculus Rift will also end up as an open source design available to anyone in time.
  • To put it mildly, this is bad news for Ericsson, Huawei, Cisco, Nokia and so on.

Third: Put itself firmly in China’s footsteps.

  • The direction in which Facebook is taking Messenger is a clear imitation of Weixin (Tencent), LINE and Daum Kakao instant message products which have become go to places to access a huge range of services.
  • Usage of mobile devices in China is far more advanced than it is in the West, and consequently it serves as an excellent model for a Western Ecosystem going forward.
  • Enabling businesses to develop bots to interact with users and making it easier to access O2O (offline to online) services such as ordering food or shopping will allow Facebook to gain a much deeper understanding of its users.
  • The Chinese ecosystems aim to grow their revenues by owning many of these services (like Alibaba does) but Facebook appears to be content just to be the enabler.
  • I think that this is because its ability to monetise its users through advertising is much greater than any of the Chinese ecosystems.
  • This ensures that Facebook will not have to make the huge investments required to get many of these services off the ground which will help to keep profitability at very good levels.

Take Home Message

  • The net result was that Facebook hardly put a foot wrong at its developer conference and demonstrated that it is on the path to become the world largest ecosystem by far.
  • The problem is that consensus is already forecasting that some of the benefits from the 10 year roadmap will come through this year.
  • I think that this is very unlikely and this is why I fear that Facebook may fall foul of over optimistic forecasts.
  • I am currently expecting this to really hit in Q3 this year but there are already rumblings that Q1 16E may fall short due to falling engagement of some users.
  • Either way, with the shares valued at 35.0x 2016 PER, there is not much scope for it to miss consensus without paying a heavy price.
  • I am waiting for this reset in expectations before I look at pulling the trigger on the long-term story which remains excellent.