Amazon vs. Google – Open goal

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Amazon Echo opens a market for Google Home to dominate. 

  • The Amazon Echo has sold reasonably well but I think that the device is not clever enough nor integrated enough to make it a must have product.
  • This leaves the goal wide open for Google Home to dominate as 60% of Amazon’s customers are already aware of the device category but only 2% of them have bought one.
  • A report from CIRP has found that Amazon has shipped 5.1m Echo devices since inception but only 30% of users use the device for information while 40% use it as a speaker.
  • A very meagre 10% use it to control the home.
  • This is a problem because unless Amazon can convince users to use Echo for things other than listening to music, it will quickly become just another speaker.
  • The problem is that Alexa, the digital assistant that resides inside Echo, is not very clever and much of the time simply does not answer even when it has heard the user.
  • Furthermore, there is no real integration meaning that the other functions of the device are not intuitive and easy to use.
  • For example: the statement “Alexa, I am cold” does not have any effect at all.
  • Instead the user must say “Alexa. Open Nest. Increase to 75 degrees. Close Nest” which can probably be done more intuitively from a mobile phone.
  • This is just one reason why the understanding of natural speech is so important and why apps and services on devices need to be able to talk to each other.
  • Consequently, I think that there is a huge opportunity for Google Home as best-in-class Google Assistant resides in the device and Google understands the importance of integration.
  • Furthermore, I think that Google is the world leader in natural speech recognition and processing and should therefore be able to deliver the best, most easy and fun to use experience of any.
  • The icing on the cake is that Amazon has prepared the market for Google Home as 60% of its customers are aware of a home speaker, that one can ask questions of, but only 2% have bought one.
  • Hence, the main issue for Google Home remains its execution to make the most of this opportunity just as it is for Google Pixel to capitalise on Samsung’s Galaxy Note 7 disaster.
  • This is a rare opportunity for Google to capitalise on the trailblazing and mishaps of its competitors but I still think that all of Alphabet’s upside has already been captured in its share price.
  • Consequently, I still prefer Baidu, Tencent and Microsoft which offer more upside although they have different market exposures to Google.

 

Ola. vs. Uber – Welfare state.

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I suspect Ola will need state intervention to survive. 

  • Ola looks to have become desperate as it appears to be pursuing a new round of funding at a valuation 40% below where it raised money just one year ago.
  • This is just yet another sign of the malaise that has hit the Indian start-up arena as Flipkart has already run into difficulties resulting in lay-offs and management change and funding for Indian start-ups is down 50% compared to the first 3 quarters of 2015.
  • This echoes exactly what happened in Silicon Valley during 2015 where much more attention was put on profitability and valuation after a series of so-called unicorns failed to execute on their plans.
  • I think there is still plenty of money available for investing in India but it is now much more difficult to get one’s hands on it and founders will end up having to give more of their companies away.
  • Furthermore, I think the departure of Nikesh Arora from Softbank has caused it to be far more passive in the region which has also had a knock-on effect on valuations.
  • On top of this, Ola’s operational outlook is looking increasingly difficult because it no longer has a significant advantage in the Indian market.
  • Car hailing is one of the best examples of a networked economy and just like classifieds it is extremely difficult to make money until one of two criteria are met:
    • First: one must has at least 60% market share or
    • Second: one must have double the market share of the next largest player.
  • Earlier this year it was thought that Ola had 80% market share but when one looks at completed rides, it turns out this number is closer to 50%.
  • To make matters worse, its chief rival Uber has roughly the same position meaning that two are likely to fight it out until one cracks.
  • In the Chinese market it was Uber that cracked as it became clear that it would never be able to compete on a level playing field with Didi Kuadi (see here) but in India things are different.
  • The problem that Ola faces is that Uber is much larger and better financed meaning that it will be able to compete aggressively and lose money until Ola goes out of business.
  • Consequently, unless the regulatory landscape shifts more in favour of the local player (as in China), it looks like Ola will end up selling itself to Uber.
  • Car hailing, like food delivery and all other online market places are winner takes all markets and there are no prizes for second place.
  • As I result, I remain concerned with the long-term outlook for Ola and I would be very cautious at putting money in even at $3bn.
  • If nothing changes, Ola is likely to end up being worth far less than that.

Microsoft – Back to front

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Back to front strategy of Surface Phone looks sure to fail. 

  • Mobile phones are a bit of a blank spot for Microsoft but 2017 is likely to see it give it another go despite the fact that Office 365’s success in iOS and Android have made this feat almost impossible.
  • It has been a very long time since Microsoft has done anything meaningful in the mobile phone and with the massive write down of the Nokia acquisition and the lay-off of the vast majority of the staff, it would almost seem that it has given up.
  • However, there is still a device in the works which will be part of the Surface portfolio to add to the excellent Surface Pro, Surface Book and Surface Studio.
  • This device will be called the Surface Phone and very much like its big brothers it will aim to be the ultimate mobile device and appeal to a certain set of users.
  • Unfortunately, I suspect that no matter how good this Surface Phone is, it will not appeal to even Microsoft’s hardest core fans.
  • This is because the mobile phone is a device that is predominantly used for Digital Life whereas the Surface products excel at Digital Work.
  • In Digital Work the Surface products are aimed at content creators and in that instance they are best in class.
  • However, every content creator is also a content consumer who predominantly uses an Android or iOS device for his Digital Life.
  • Therefore, Microsoft will have to make its Digital Life offering utterly compelling to convince even these users to move their Digital Lives to Microsoft and in that regard I see nothing but neglect and malaise.
  • This is why the Surface Phone will fail because no matter how good the hardware is, the ecosystem has deteriorated to a point where most of the apps that the user would want are not available.
  • Microsoft’s coverage of the Digital Life pie has deteriorated from 71% to 57%, developers are rapidly deserting the platform and user numbers are in free-fall.
  • This is how Microsoft has it back to front as users tend to being their digital lives with them into Digital Work and not the other way around.
  • Furthermore, the fact that Microsoft has made good quality versions of Office 365 available for iOS and Android devices substantially reduces any reason to buy a Surface Phone.
  • I have long believed that Microsoft’s most valuable asset is Office 365 meaning that it is in Microsoft’s interest to ensure that it works as well as possible on as many devices as possible.
  • Therefore, using Office 365 as a differentiator for the Surface Phone could actually do more damage than good to Microsoft as it could dent Microsoft’s reputation on the other, far more important platforms.
  • Hence, the only option would be for these users to have two devices, one for Digital Work and one for Digital Life.
  • However, because iOS and Android offer Microsoft’s Digital Work services to an acceptable level of quality and because the Surface Pro and Surface Book are so good at Digital Work and so portable, there is no reason whatsoever to buy the Surface Phone.
  • Hence, I think Microsoft would be best served in quietly dropping this idea and focusing its resources on the things that it does best and where it can succeed.
  • I think the mobile phone ship has already sailed.
  • Despite the inevitable disappointment, Microsoft’s share price does still not fully reflect the opportunity available in Digital Work which is why I still like it alongside Tencent and Baidu.

 

 

Handset Industry – Oranges and lemons

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I think Apple earns between 64%-68% of industry profits, not 91%. 

  • I believe the notion that Apple makes almost all the profits in the mobile phone industry is not accurate because Apple’s handset margins are underpinned by both hardware and its ecosystem.
  • Strategy Analytics has analysed the profits of the global handset makers and concluded that of the $9.4bn in industry profits in Q3 16A, Apple accounts for 91% of them (see here)
  • To get the real picture, I think one must either separate the ecosystem from the hardware or include companies like Google which has effectively drained the Android industry of its profitability.

Separate ecosystem from hardware.

  • In order to do this, one has estimate what margins Apple would make if iOS did not exist and it was merely a handset vendor selling Android devices.
  • In Q3 16A Apple sold 45.5m devices with an ASP of $625 giving revenues of $28.44bn and EBIT of $8.5bn giving an EBIT margin of 29.9%.
  • If Apple was selling Android devices, I suspect that its gross margin would be around 20% and its EBIT margin 4-5%.
  • This leads me to believe that in Q3 16A Apple made $1.4bn in profits from hardware and $7.1bn from its ecosystem.
  • This is a fairer comparison to the other handset makers who don’t have an ecosystem and using Strategy Analytics’ numbers would lead me to include that hardware profits of the industry were $2.2bn of which Apple earned 64% and the Android handset makers 36%.
  • It is important to note that Samsung’s dreadful Q3 16A due to the Note 7 has substantially skewed the current numbers in Apple’s favour.

Include the ecosystem.

  • I have long believed that the real difference between Apple and Google is much less than many commentators believe.
  • Both companies own global ecosystems from which they derive most of their profits.
  • However, they monetise them in different ways (hardware for Apple, advertising for Google).
  • Consequently, to compare oranges to oranges, one must include the profit that Google generates from mobile devices to get a real picture what is happening in the industry.
  • I have excluded the Chinese ecosystems from this analysis for reasons of simplicity and the fact they only operate in China.
  • In Q3 16A, RFM estimates that Google generated $7.8bn in revenues from mobile devices upon which it made margins of at least 40%.
  • This means that the mobile ecosystem generated $3.1bn in profits for Google which I have long believed comes at the expense of the Android handset industry.
  • This means that hardware and ecosystem profits (adjusting SA’s numbers) in total were $12.5bn of which Apple earned 68%, Google 25%, leaving the Android handset makers with just 7%.

Take Home Message.

  • Whichever way one cuts the cake, comparing oranges to oranges or lemons to lemons, the end conclusion is the same:
  • Apple earns the majority of the industry’s profits but it is not the huge 91% that a simple calculation indicates.
  • Furthermore, the re-addition of Samsung into the mix once it has got back on its feet after the Note 7 disaster will further reduce Apple’s real share of industry profits.
  • I expect that as time passes, more and more of the profits of the consumer device industry will be made by those that have ecosystems at the expense of those that do not.

Meitu – Crazy selfies

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Very risky proposition leaves too little on the table. 

  • Meitu has 446m active users but its revenue comes almost exclusively from selling smartphones which is unlikely to convince investors to pay $6bn at IPO.
  • Meitu was founded in 2008 but really came to attention with the creation of a series of apps that focus on selfies, photo editing, beauty and fashion.
  • This is because its main app, Mitu Xiu Xiu, has 446m MaUs which has spawned a whole series of related apps that allow for make-up or other adjustments to be made to selfies.
  • As a result of its huge success in winning users, it has filed for an IPO with the Hong Kong Stock Exchange and hopes to raise around $500m at a valuation of $5bn – $6bn.
  • This is where the wheels become to come off as in H1 2016 the company generated just RMB585m ($85m) in revenues of which 95% came from the sale of 290,000 smartphones.
  • Meitu made 20% gross margins on these devices which is line with the rest of the smartphone industry and leads me to believe that EBIT margins on its devices are around 2-4% in the best instance.
  • On that basis alone I would not pay more than $150m valuation for Meitu but there is the app business to consider.
  • A user base of 446m is potentially worth a vast amount of money but only if ways can be found to monetise those users.
  • This is where Meitu is really struggling as it is currently generating RMB0.01 per user per month from its apps or around $8.5m per year.
  • RFM’s assessment of the Chinese Digital Life pie estimates that the total opportunity is around RMB8.50 per user per month with 100% coverage.
  • I think that Meitu’s apps cover 17% of the pie giving a total maximum opportunity of RMB1.44 per user per month.
  • If I gross this up to estimate the maximum revenues Meitu could generate if it executes flawlessly, I end up with a figure of RMB7.73bn or $1.12bn per year.
  • This could reasonably be expected to grow at around 7-10% per year should this goal ever be hit.
  • If I benchmark this performance against Tencent, I can reach a blue-sky valuation of $9bn.
  • The issue is that an IPO at $6bn means that investors are already paying 66% of the best-case scenario which I think skews the risk substantially to the downside.
  • Furthermore, there are already signs of waning popularity as Meitu’s apps are nowhere to be seen in the Chinese app store charts unless one looks in the reasonably obscure photo and video category.
  • Consequently, I think that the decision to invest has to be based on an assessment of the management’s ability to execute on the monetisation of its apps and even then I would be looking for a substantial discount to the proposed price.
  • If I was hugely confident in the management and its ability to execute as well as fend off the threats from its far bigger and more powerful competitors (Baidu, Alibaba and Tencent), I might be convinced to pay a post IPO valuation of $2.5bn.
  • Given that it raised money in April 2016 at a valuation of $3.7bn, I suspect that the IPO will have to come at a value far above that which I consider fair.
  • Another IPO to avoid.

Facebook – The dunce pt. II.

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Inability to automate bites Facebook again. 

  • Facebook’s problems with fake news once again demonstrates the real problems that this company has with anything complex that is not carried out by a human.
  • During the recent presidential election, it became clear that a large number of users rely on Facebook, Twitter etc. for current affairs rather than the traditional news broadcasters.
  • This puts a huge responsibility on these players to only disseminate stories which are factually accurate which is something that Facebook in particular has been struggling with.
  • Facebook has reacted quickly to address this issue but the remedies that it is putting in place reveal once again that Facebook relies almost completely on humans to carry out intelligent tasks.
  • Facebook’s remedies to address fake news include:
    • First: Use third party organisations as fact checkers
    • Second: Verifying information with journalists.
    • Third: Relying on the community to report fake news.
  • Very much like Facebook M and Facebook’s bots, this remedy relies almost exclusively on humans to solve difficult problems, highlighting yet again how weak Facebook is when it comes to artificial Intelligence (AI).
  • This is a problem because humans are extremely expensive compared to machines and with the high level of traffic and content growth that Facebook is experiencing, quality checking is already a massive task and will only become greater.
  • Facebook is trying very hard in AI and is recruiting as fast as it can, but AI takes a very long time to get right and I am concerned that Facebook will end up with a much higher cost structure than its rivals.
  • This will mean that it will have a higher cost base than Google or Baidu leading to lower profitability.
  • Given Facebook’s late entry into AI, I think that it will have to buy its way out of these problems because growing it organically is likely to take much too much time.
  • Although this is a very serious problem, I have some confidence that Facebook will be able to sort it out.
  • This confidence is based on the exceptional execution and implementation of a system for monetisation of mobile that led to mobile becoming the majority of Facebook’s revenues in a very short period of time.
  • This problem is much more difficult to solve but I am hopeful that Facebook’s exceptional record in execution will see it through.
  • This is yet another reason to be cautious on Facebook in the short-term (see here) but assuming that this is fixed, I continue to look for an entry point into the shares during 2017 or 2018.
  • In the meantime, my preference remains Microsoft, Baidu and Tencent.

Facebook – Middle age spread

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An opportunity lurks under the image of a maturing company. 

  • Facebook continues to show all the hallmarks of becoming a maturing company but I suspect that there is another leg of very rapid growth just waiting to happen.
  • In addition to a difficult set of results, where Facebook admitted that its growth was going to slow down meaningfully in 2017 (see here), Facebook has announced in an SEC filing that it will buy back up to $6bn worth of its shares.
  • This is a classic move that all companies make when they begin to transition from rapid growth into middle age.
  • It is a sign that the company does not know how to invest the money that it has generated to earn a good return for shareholders and so it decides to return the money to them instead.
  • However, there is a big difference between buying back shares and actually returning that money to shareholders.
  • I have long believed that to return money to shareholders a company must also cancel the shares that it purchases.
  • It is only as the total number of diluted shares declines and EPS is enhanced can the money be deemed to have been returned to the shareholder.
  • Most companies in the technology sector do not do this and instead use the shares that they have bought back to cover options programs and restricted stock unit awards.
  • Consequently, although they claim that they are returning cash to shareholders, very few of them actually do and I suspect that Facebook will be just the same.
  • Even, Microsoft, which aggressively buys back shares every quarter, only manages to return around 66% of the money to shareholders with the other 34% being used for share compensation programs.
  • Global leader in this area is Samsung which has promised to cancel every single share that it buys back thereby ensuring 100% of the money goes back to its shareholders.
  • Although this is a classic sign of a maturing company, I think that Facebook still has a trick or two up its sleeve.
  • Today, I calculate that Facebook monetises just 35% of the Digital Life pie but if I include the ecosystem that it is building, I could take this figure to 80%.
  • The problem is that the other assets, and the ecosystem itself, are not yet mature enough to start generating revenue and this is why I see a period of much more modest expansion.
  • Once these assets are mature, then I think Facebook will begin to grow quickly once again creating an opportunity to own the shares once all the bulls have given up hope.
  • Hence, I am keeping a very close eye on Facebook as depending on how its assets develop, there may be a great opportunity to get in during 2017 or 2018.
  • In meantime, I see continued disappointment as straight-line obsessed analysts continue to reduce their short-term (and by default long-term) estimates and rue the end of rapid growth.
  • While I wait, Tencent, Microsoft and Baidu look like good places to camp out.

Intel – Data dreaming

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Intel is doing what it must to keep its position in the Data Centre. 

  • Intel has launched its attack on the field of Artificial Intelligence (AI) with a series of initiatives aimed at easing the compute load but seems to completely miss the fact that the real challenges of AI are based on software not hardware.
  • At a special event in San Francisco, Intel detailed its strategy to address AI and at the same time relaunched an AI compute platform it acquired from Nervana.
  • Intel’ strategy includes:
    • First: A new Intel product called Knight’s Crest that tightly integrates Xeon processor with Nervana’s computing platform that is built from the ground up for AI.
    • Second: An update to the Xeon Phi processors (Kinghts Mill) that will be available in 2017 that will deliver a 4x improvement in AI computations.
    • Third: Intel has launched a series of initiatives to ensure that the platform it is offering is both easy to use and as widely available as possible.
    • This includes the release of developer tools and a series of initiatives aimed at driving engagement with the AI community, higher education and schools.
  • This strategy is exactly what Intel needs to be doing as it plays directly to its strengths in terms of designing the best performing processors but its commentary shows that it has not understood what the big challenges of AI are.
  • Intel confidently expects that the Intel Nervana platform will provide a dramatic reduction in the time required to train neural networks and promises to deliver a 100x improvement in performance by 2020.
  • However, I think that Intel has missed the fact that the big challenges faced by AI today have very little to do with the ability to crunch data.
  • The biggest problems with AI are:
    • A vast amount of data is needed to train an AI because the algorithm needs to see a lot of examples before it can draw any conclusions.
    • A trained AI cannot transfer what it has learned to any other task.
    • Building and adjusting the models during training is a manual and very time consuming task.
  • I believe that it is these issues that are holding up progress in AI and no amount of raw horsepower is going to meaningfully speed up the solution of any of these problems.
  • Consequently, while Intel might deliver a 100x increase in performance in number crunching, it won’t be until the programmers have figured out how to train AIs with less data or to have the machines build their own models that AI takes a big leap forward.
  • The net result here is that Intel has produced a product line-up that should help preserve its dominant position in data centre processors but it will not suddenly make Intel a nerve centre for AI.
  • If Intel can encourage all of the AI industry to run its models on Intel processors, then the threat from ARM in the data centre will be meaningfully reduced.
  • Intel is merely doing what it must to ensure that its hugely dominant and highly profitable products are relevant for the next generation of data centre computation.

Tencent Q3 16A – Work in progress.

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Still a lot of work needed to realise its full potential. 

  • Tencent reported another excellent set of results but the fact that expectations are already so high meant that the numnbers felt more like a damp squib.
  • Q3 16A revenues / EPS were RMB40.4bn / RMB 1.12 compared to consensus at RMB39.0bn / RMB 1.17 and RFM at RMB35.3bn / RMB 1.15.
  • The combination of greater investments being made in sales and marketing and a higher tax rate was responsible for the lower profitability that the company experienced.
  • When one looks at gaming, the importance of the transition that Tencent is going through becomes apparent.
  • Although Tencent did manage to grow revenues from PC gaming, the daily active user count was down by 9% YoY and the number of concurrently active users for casual PC-based games was down 18% YoY.
  • This is an indication that usage is shifting to mobile and that PC users are spending more time playing each other rather than on their own against the AI.
  • Tencent has responded to this by offering more game related activities such as tournaments, video streams of popular gamers and so on.
  • This shift is also nudging Tencent closer and closer to becoming a fully-fledged ecosystem but in that regard, there is still a lot of work to do.
  • Its biggest assets here are Weixin / WeChat, its social network Qzone and its mobile gaming offering.
  • All together Tencent has 77% coverage of the Chinese Digital Life pie but its assets remain quite disparate and fragmented and it is this that needs to change.
  • Tencent needs to become the place where Chinese users go to spend 77% of their digital lives perhaps with the occasional outing to Alibaba to shop and Baidu to search.
  • To achieve this, Tencent needs to fully integrate its offering and make it as consistent, easy to use and as fun as possible.
  • Tencent shows little sign of doing this on the surface but the investments that it is making in data centres and in sales and marketing are some indication of what is taking place behind closed doors.
  • This is encouraging because on its current trajectory, Tencent is heading for a big slowdown in 2017 and beyond as the Chinese market matures.
  • However, RFM calculates that Tencent is very far away from fully monetising the ecosystem that it is creating, meaning that there is an opportunity for another leg of growth in the medium-term.
  • To achieve this, Tencent needs to really integrate all of its assets into a single experience for users rather than a series of different services.
  • It is at this point that further growth is possible both in terms of profits and the share price.
  • However, I don’t see Tencent being ready to grab this opportunity in 2017, and so in the short-term a slowdown looks inevitable.
  • The good news is that even without the ecosystem there is still some headroom in Tencent’s valuation.
  • Hence, I am happy to keep it on my list alongside Microsoft and Baidu.

Google – Gain in translation

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Google is not resting on its laurels when it comes to AI. 

  • A vastly improved Google Translate is yet another sign of how far ahead Google is when it comes to tackling the key AI problems that need to be solved to take Digital Life services to the next level.
  • Google has updated the translation engine for 8 of its most used languages (covering 35% of all translation queries) to use a new translation technique called Neural Machine Translation (NMT).
  • Almost all machine translators break up a sentence into separate words or phrases and translate them independently which results in usable translation but often crucial nuances are missing.
  • NMT takes both the entire sentence into consideration and the broader context which allows a more relevant translation which is then rearranged and adjusted to be more like the way a human would write or speak.
  • Like all neural based systems, NMT learns as it goes meaning that it requires a lot of usage in order to improve.
  • Google Translate is already one of the best machine translation systems available and hence I do not think that it will suffer from a lack of data from which to learn.
  • On the articles I have tested, there has been a very noticeable improvement in the fluency of the translation compared to the previous version, although it is still not difficult to tell that it has been translated by a machine.
  • I think this evolution is important because it has implications for Google’s ecosystem that go way beyond translation.
  • AI is becoming increasingly important in terms of determining the functionality and usefulness of Digital Life services but there is another requirement that sits on top.
  • This is the requirement to be able to understand and interact naturally with the user as well as have better insight into the data that the user generates.
  • If the system does not understand the user or his data properly then even the best AI will almost certainly fail to provide a decent service.
  • This is why this update is important as it speaks volumes about the edge that Google has in understanding what it is the user is asking for.
  • Being able to translate naturally requires an understanding of natural speech which I think is the first requirement for a decent personal digital assistant.
  • Personal digital assistants are the first real delivery of an AI driven service to the user and all of the major ecosystems are actively developing an offering.
  • Hence, I am increasingly confident that Google remains far ahead of its peers when it comes to AI meaning that its services could become more relevant, useful and easy to use when compared to those of its competitors.
  • This in turn, should drive more traffic to its servers resulting in greater opportunities for monetisation.
  • That being said, I still think that much of this has already been discounted in the Alphabet share price and I am not keen to get in at these levels.
  • I would prefer Microsoft or Baidu at these levels.