Tencent – Feathering the nest

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Rovio could help Tencent spread its wings.

  • Rovio is almost certainly past its prime but it has an asset that could be capitalised on should the right buyer come along.
  • Tencent is not showing any real signs of being the right buyer at the moment but its ownership of Supercell makes Rovio a good strategic fit.
  • Rovio is the creator of the well-known Angry Birds franchise where its revenue from games has been revitalised by the recent good performance of the Angry Birds movie.
  • 2016 revenue / EBIT was Euro190m / Euro17.1m with a bump in games, thanks to the movie, bringing the company back into profit.
  • The revenues from the movie will be recognised over the 2017 and 2018 financial years.
  • Tencent has had some success in taking Western games and leveraging them into China as League of Legends has become a major hit in China through Tencent’s patronage.
  • I have been fairly disappointed with Tencent’s acquisition of Supercell so far as while it is now able to leverage Supercell’s hugely popular games into China, I think the real opportunity lies outside.
  • The Chinese market is starting to slow meaning that the BATmen will need to look elsewhere long-term for sources of growth.
  • Of all of the BATmen, Tencent has the greatest opportunity as the Digital Life segment in China within which it is the strongest remains unoccupied in developed markets.
  • This is kargely because the big multiplayer gaming communities Xbox Live, PlayStation Network, Valve (see here) have all failed to leverage their communities from PCs and consoles into mobile.
  • Activision Blizzard, which I think purchased King Digital exactly for this purpose, is also not doing a great job of it as active users of King mobile assets have gone into freefall.
  • This leaves the way open for Tencent to begin to build its assault on developed markets starting with the all-important segment of Gaming which it dominates at home.
  • However, it has not shown much intent to make the most of this opportunity instead concentrating on leveraging overseas games into its home market.
  • In Supercell it considers itself to be a financial investor which is why it seems to have been left pretty much to its own devices.
  • Rovio would be a good fit for Tencent alongside Supercell but I still think that the real opportunity lies in using these assets to grow its presence overseas.
  • Tencent has by far the strongest ecosystem in China with 77% coverage of the Chinese Digital Life pie which is why I think there is so much upside.
  • It makes almost all of its money from selling media and games with only a small proportion coming from monetisation of the ecosystem it has created.
  • If it was to effectively monetise its ecosystem at home and aggressively push into developed markets, it could become one of the biggest digital ecosystems globally.
  • However, there is still a long way to go in recognising this opportunity and it needs to structure its assets appropriately to take advantage of that.
  • Consequently, I don’t see Tencent seeing the benefit of this for some time to come but the good news is that there is still enough growth left at home to sustain the valuation for a while.
  • Tencent, alongside Baidu and Microsoft are my favourite ecosystems at the moment.

Airbnb – American losing streak

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Airbnb unlikely to win in China.

  • Airbnb, like Uber and Amazon before it, has fight on its hands when it comes to the Chinese market meaning that it will have to do something very different to break the current losing streak.
  • Apple is the one exception which I think is due to its brand strength with Chinese consumers and the fact that its success in China has not really come at the cost of local companies.
  • Although Airbnb dominates the global market for short-term private rentals, it is relatively small in China with around 80,000 properties available for rent.
  • By contrast, local competitor Tujia.com (which shares listings with Ctrip.com) has 400,000 and an additional 300,000 low cost listings.
  • The smaller local player, Xiaozhu.com, boasts 200,000 covering 300 cities which combined with Tujia.com, dwarf Airbnb by a factor of over 5 to 1.
  • Furthermore, these local competitors are well financed having closed significant funding rounds recently with plans for more as they grow.
  • Airbnb, Amazon and Uber are all network based businesses meaning that, to make money in any one market they need to dominate it.
  • The rule of thumb that I use to judge when this can happen remains as follows:
  • To make money, a network business needs to obtain at least 60% market share or be double the size of its nearest competitor.
  • Once this has been achieved that market place will have become the go to place to buy or sell something.
  • That way, buyers will become less price sensitive on that market place and the market place can charge sellers more to transact there.
  • There are some doubts with regard to how many of the listings on the local sites are ever rented, but even if it is a small percentage, the locals are still likely to be bigger than Airbnb in China.
  • This is why I suspect that Airbnb tried to buy Xiaozhu.com last year as this would have given it a critical foothold from which to grow into the dominant position that it needs to become viable in China.
  • The local players also appear to have a better feel for the demands for domestic customers while Airbnb does much better with foreigners coming into China for business or tourism.
  • Hence differences in the requirements and language between local and foreign renters will keep the local companies from turning the screws on Airbnb for the moment.
  • However, once they are established for domestic renters, I can see them quickly turning to embrace non-Chinese users and as ever, they will be brutally price competitive.
  • I think that this gives Airbnb some time to build a local presence but given the difference in vlume between domestic and foreign rentals, it is unlikely to dominate the market without competing directly with Tujia.com and Xiaozhu.com.
  • This is when the blood-letting is likely to begin and given the experience of Uber and Amazon it is not going to be pretty.
  • Given, that Airbnb appears to be already way behind in the market for domestic rentals, this looks like a fight that it will not win meaning that it will end up selling its China operation to one of the local players.
  • I doubt that Airbnb will be the one that breaks the American losing streak in China.

DJI – Brains not brawn

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The spark at DJI is in its software prowess.

  • DJI has launched a new drone which I think clearly demonstrates this company’s unique ability to take on its US rivals and come up with a better product.
  • DJI has launched the Spark which is a palm sized drone that looks to be so easy to fly that the controller is an optional accessory.
  • The Spark is equipped with a 1080p 12MP camera and is controllable with a smartphone app but most importantly it sports a level of autonomy that makes it easy for anyone to fly.
  • Its chief rival in this space is the Dobby drone from Xerotech, which is pretty easy to fly using a smartphone but does not offer the level of sophistication that the Spark does.
  • Specifically, I am referring to the ability to completely control the drone using hand gestures and a series of autonomous modes that are aimed at still and video selfies.
  • This level of autonomy has been under development for quite sometime and DJI continues to demonstrate that it is ahead of all its competitors, including those based in US.
  • This is extremely rare for a Shenzhen-based hardware company which tend to turn out very cheap copy-cat devices and have no understanding of software at all.
  • The difference between Chinese designed devices and the much more expensive versions sold by US companies tends to be found in software functionality and reliability.
  • This is why the US versions still sell well in developed markets as consumers can recognise and are willing to pay up for quality products.
  • DJI completely bucks this trend as it is turning out better products than all its competitors making it a worthy leader of the still small, but growing drone market.
  • What is unusual about DJI is that its differentiation is now rapidly becoming based on its software which offers the best level of autonomy currently available.
  • This has really come to light in its two most recent products, the Mavic Pro and now the Spark.
  • The Spark is DJI’s first attempt at the consumer market as the device is priced at $499 compared to all of its other products that are above $1,000.
  • For its more expensive products it is not so important for them to have a high level of autonomy as they tend to be purchased by users who are either professionals or experienced flyers.
  • This is aimed at those that have never picked up a drone before and as long as it lives up to its billing it should be very easy and great fun to fly.
  • Most of all, the autonomy should allow selfies to be taken where the “pilot” is participating in the scene rather than flying the drone.
  • DJI is continuing to stay ahead of its competitors and is the first Chinese company to lead a segment of consumer electronics rather than be a fast copier.
  • If it was listed, I would be looking at DJI with great interest.

LeEco – Le-trenchment

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LeEco looks to return to its roots at home.

  • LeEco’s foray into the United States looks like it is coming to an end which combined with a major restructuring at home, probably brings to an end any realistic hope of becoming a digital ecosystem.
  • I understand that LeEco is about to lay off all of its employees in the US that are involved in developing, building and selling the devices and ecosystem that LeEco is offering.
  • Those that remain are thought to be staying to look after existing customers but I suspect that most that remain will be the ones that are working on the automotive ambitions of Faraday Future.
  • On top of this, Jia Yueting, the mercurial founder of LeEco, is also stepping back from his position as CEO of Leshi Internet Information & Technology Corp. (LeEco’s parent) although he will remain chairman.
  • He will be replaced by Liang Jun who has been running the content business since joining from Lenovo in 2012.
  • LeEco’s CFO has also been replaced with the CFO of the China business.
  • Furthermore, it looks like all of the content related businesses will be merged into Leshi while the automotive business is spun out as a separate unit.
  • All of this points towards a big retrenchment where LeEco will once again become a Chinese digital content company with a shareholding in an electric car company.
  • I think that this means that all LeEco’s activities in the US will be focused on Faraday Future which is trying to build an electric vehicle at a yet-to-be-completed factory in Nevada.
  • At the end of the day, I think LeEco tried to do things much too quickly and did not pay enough attention to the fundamentals of creating an ecosystem.
  • If I take LeEco’s ecosystem as it is today it has weak coverage of the RFM Digital Life Pie as it really only covers Media Consumption.
  • It also gets a poor score against RFM’s 8 Laws of Robotics mostly due to the fact that it has not paid enough attention to detail when it comes to the user experience.
  • I get the impression that the software was simply ported over from the Chinese version and not enough time has been taken to adapt the user experience for the US consumer.
  • The devices themselves offer great value compared to competitors with an 85 inch 4K TV for $5,499 being the best deal available by quite some margin.
  • However, it all falls to pieces when it comes to software and this is where LeEco was hoping to make its money.
  • I have long held the opinion that LeEco did not have the resources to create both a digital ecosystem and an electric vehicle and that it should close its automotive operation and focus on its core business (see here).
  • However, it appears to have gone one step further in closing its ecosystem ambitions and spinning out automotive where I suspect it will be seeking participation from other investors.
  • I suspect that Leshi will now return to competing in the Chinese market which is heating up with increasing levels of investment in content coming from the BATmen.
  • Consequently, the outlook is pretty bleak as Leshi’s ability to out invest the BATmen is highly questionable especially given the troubles that it has had with expanding into the US.
  • I would pick Tencent as my favourite Chinese ecosystem for investment.

 

Alibaba FQ4 17 – Intuitive integration

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Signs that Alibaba is moving to make the most of its ecosystem.

  • Alibaba reported another excellent set of results which was marred by the normalisation of the tax rate following the ending of a tax break gained by investing in its distribution partner Suning.
  • Alibaba has also begun to demonstrate the kind of traits that lead me to think that it has really figured out what it needs to do to become a fully-fledged ecosystem across all aspects of its users’ digital lives.
  • FQ4 17 revenues / Adj-EPS were RMB38.6bn / RMB4.35 nicely ahead of consensus estimates of RMB35.9bn / RMB4.86.
  • The main driver of the results was Alibaba’s core e-commerce business which posted FQ4 17 revenue growth of 47% to RMB31.6bn.
  • This was underpinned by 11% growth in the number of active buyers as well as each user spending significantly more with Alibaba than they have in the past.
  • This is how Alibaba has managed to defy my expectations that growth would slow this year.
  • Cloud computing and digital media and entertainment each posted triple digit growth albeit from a much lower base.
  • The excellent results were marred by an increase in the tax rate which increased to 23% up from 14% in FQ4 16 where it will stay from here.
  • The most notable aspect of management’s commentary was the increasing focus on integration of its digital assets.
  • This has almost been completed for the digital media assets, giving Alibaba the ability to understand usage patterns across all of its media assets.
  • The same thing is going on in its e-commerce assets and it is already beginning to reap the benefits from this by offering this intelligence back to the merchants on its sites.
  • This kind of intelligence is what could also allow Alibaba have a big impact in offline retail which still makes up the vast majority of Chinese retail spending.
  • The final step should end up being the integration of all of this data into a single repository.
  • If Alibaba can to this effectively, it will be able to monetise its traffic far more effectively than it does today as well as have the insight into its services to make them richer and better than those of its competitors: Tencent and Baidu.
  • I still struggle with the valuation of Alibaba but it’s moves towards really making the most of the assets it has makes me willing to have another look.

Alibaba – US breakthrough.

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Deal with First Data changes the US game.

  • Alipay has struck a deal with First Data Corp. that I think prepares the ground for Alibaba to re-enter Amazon’s home market, the US.
  • Alibaba has already made an attempt to enter the US with 11 Main which was sold less than a year after it launched to OpenSky in what can only be seen to have been an embarrassing early exit.
  • Since that sale, Alibaba has been licking its wounds and as a result has come up with what I think is a far more effective strategy to take on Amazon in its home market.
  • The Trojan horse is Alipay which is actively used by 450m Chinese users whose business, US retailers are keen to attract.
  • Alibaba began by negotiating with each of the retailers individually offering the possibility to sell their products into China as well as attract Chinese tourists to shop.
  • However, this deal moves this strategy into a whole other dimension as once Alipay is fully implemented, it will be accepted by 4m retail outlets across the US.
  • This puts Alipay on par with Apple Pay in terms of outlets covered making it much easier for the 4m Chinese who visit the USA every year to pay for goods and services.
  • Now that Alipay will have very good coverage of US retail, it will then be in a position to encourage US users to use Alipay for their shopping.
  • However, I think that this will be easier said than done as Alipay’s QR code system of payment leaves a lot to be desired when it comes to an easy and fun user experience compared to other offerings in US.
  • I have long believed that this experience is acceptable in China because the alternative, offline experience that it replaces is woefully bad.
  • Therefore, an experience that is mediocre by developed market standards is a huge improvement on the offline experience in China which is why I think QR codes have worked in China but failed in developed markets.
  • However, assuming that Alipay can convince US users to use it, then this would open the path for Alibaba’s e-commerce to return to the US with a much greater chance of success.
  • I think that this is the long-term strategy for Alibaba to expand into overseas markets but in the meantime making it easy for Chinese tourists to spend money abroad is going to do no damage to improving their loyalty when they are at home.
  • While Alipay dominates payments for ecommerce in China, elsewhere it is not so strong and it is WeChat Pay that does very well in that space.
  • Hence, Alipay has a fight on its hands to expand outside of e-commerce and generating loyalty with 4m of its highest spending users will do it no harm.
  • I do not see this as a threat to Apple Pay, due to the ease of use issue, but then I think Apple Pay has usage problems of its own (see here).
  • I continue to struggle with the valuation of Alibaba as I think e-commerce in China is likely to slow by more than many expect and Alibaba has a long way to go to start making real money from its other ecosystem assets.
  • I prefer Baidu or Tencent in China.

LeEco – Le Crunch.

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Crunch time appears to be fast approaching.

  • The LeEco proposition seems to be quickly unraveling as a flurry of bad news reinforces my view that this company only really has a chance if it dumps automotive.
  • New blows upon the already bruised company include:
    • Vizio: LeEco and Vizio have called off the $2bn acquisition by LeEco stating that regulatory hurdles got in the way.
    • Vizio was supposed to give LeEco a US brand with which to get a toehold in the US market while the Chinese market would become more open to Vizio.
    • I suspect that LeEco was having difficulty getting the money it raised from Sunac (see here) out of China giving it a good reason to back out of an acquisition that now makes less sense given LeEco’s current predicament.
    • 2016 revenues: LeEco appears to have massively missed its 2016 US revenue target but given that it launched in October this is hardly a surprise.
    • It looks like 2016 revenues were just $15m compared to a target of $100m but given the late launch, this target looks to have been way too ambitious.
    • Consequently, I don’t think that this reflects as badly as it would seem on the management of the US operation.
    • Job cuts: LeEco also appears to weighing up more job cuts with 175 of the 475 US workforce expected to be cut.
    • This does not come as a big surprise given the cash crunch that the company admitted to at the end of 2016 and the problems the company is having in getting money out of China.
    • However, growth companies tend not to need job cuts raising questions about the products being offered and the services that come with them.
  • This news comes on the back of abandoning its ambitious plan to build a US HQ with 12,000 employees (see here) and severe pressure being placed upon its automotive strategy.
  • Giving up the acquisition will massively increase cash for investment in the ecosystem but if it remains unable to get money out of China, not much development is likely to happen.
  • I find this situation strange as its competitors, Xiaomi, Baidu, Alibaba and so on all have substantial overseas operations which are most likely to be financed from China.
  • In my view, the biggest issue remains automotive as it has very little to do with the development of an ecosystem and is hugely capital intensive.
  • Apple and even Tesla have found that building cars is a difficult business that requires a lot of time and very deep pockets.
  • Faraday Future clearly needs hundreds of millions of dollars of new investment which LeEco simply cannot afford if it is to have any chance at delivering on its ecosystem ambitions.
  • Hence, I think that LeEco’s best interests will be served by not having this millstone hanging around its neck.
  • I continue to believe that for LeEco to have the best chance of succeeding, it needs to extract itself from Faraday Future and forget about self-driving cars.
  • Building a thriving ecosystem is difficult enough and throwing in cash constraints and management distractions can only make it next to impossible.

Xiaomi – No favours

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Xiaomi’s ecosystem remains its biggest weakness.

  • Comparing itself to Costco helps Xiaomi’s valuation somewhat but does no favours when it comes to its business model.
  • In a recent interview, Xiaomi founder said that he sees his company more like Costco than Apple which does make some sense.
  • Xiaomi has pursued a typical Internet economy model which is to gather users as quickly as it can and then monetise when their numbers hit critical mass.
  • It has done this by selling nice looking devices at very low margins and then hoping to monetise users through its ecosystem of services.
  • What Costco does is similar in that it sells groceries at wafer thin margins and makes good margins on the subscription that it charges for membership.
  • However, where Costco and Xiaomi differ is that Costco has a service that users are clearly willing to pay for but I am not convinced that Xiaomi does.
  • Around 15% of all Chinese users have a Xiaomi phone but RFM research indicates that it is the ecosystems of the BATmen (see here) that Xiaomi’s users predominantly use.
  • This strongly implies that users are buying Xiaomi phones due to attractive prices and form factor but do not care about the ecosystem that Xiaomi offers.
  • Overseas the situation is even worse because outside of China, Xiaomi sells its devices with the Google ecosystem installed because its own ecosystem is irrelevant.
  • This is the critical difference between Xiaomi and Costco.
  • I have previously estimated that Xiaomi does make some money from selling content and games ($100m in 2016 (see here)) but this is very far from Xiaomi successfully monetising its ecosystem in China.
  • To try and restore growth, Xiaomi is going into retail and plans to open 1,000 stores in China as well as a good number in India with revenues of $10bn targeted within the next three years.
  • This is the right strategy to break out of the limitations of Internet-only sales, but will have the impact of increasing costs.
  • Consequently, I am comfortable that Xiaomi could hit its RMB100bn ($14.4bn) sales target for 2017, but I am certain that margins will not be going up.
  • If I take this outlook and compare it to Costco rather than Apple, I do get a slightly better valuation but not one that would make Xiaomi’s current shareholders very happy.
  • Using Costco’s 2017 EV/Sales and EV/EBIT multiples and applying them to my estimates for 2017 Xiaomi (see here), I end up with valuations of $8.6bn / $8.3bn respectively.
  • However, in using this methodology, the question needs to be asked should Xiaomi trade at a discount because Costco has already established the service it sells whereas Xiaomi has not?
  • This is somewhat higher than my current $5bn valuation using Apple, but still way below the last raise at $45bn and the $20bn or so where I understand that the shares are changing hands.
  • I do not see any threats to Xiaomi’s viability as a company but I still think it would make a good acquisition for one of the BATmen that I think will need to become more vertically integrated to continue growing in the home market.

Didi – Nasty economics

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Didi encounters a real growth problem.

  • Didi is now the only credible ride hailing platform left in the Chinese market, but its problems are far from over because local Chinese governments are finally enforcing regulations designed to protect the taxi industry.
  • In December 2016, the governments of Shanghai and Beijing approved a policy called local cars, local drivers.
  • This meant that ride hailing companies could only use drivers who had locally registered vehicles and could prove residence in the city.
  • This may not sound like a big deal until one looks at the demographics of the urbanised workforce in China.
  • Around 40% of the workforce of both of these cities reside outside of the city and in the younger, paid part of the workforce, that number is much higher.
  • For example, prior to the enactment of this regulation, less than 3% of Didi’s Shanghai drivers had the necessary residential registration to qualify as drivers.
  • I suspect that that Didi’s Beijing drivers show similar characteristics and that other major Chinese cities also have a large migrant workforce.
  • This has not become a problem until very recently because although the policy has been approved, it has not been enforced until very recently.
  • The result has been that Didi has now been forced to substantially reduce the number of drivers in Shanghai and as of April 1st, is only allowing cars with a Beijing licence plate to operate in Beijing.
  • The net result is that supply of rides has been drastically reduced meaning that the price of those rides will inevitably increase.
  • Furthermore, on top of the service becoming more expensive, the quality of the service is also likely to meaningfully decline.
  • With less cars available, wait times will certainly rise and the chance of successfully hailing a ride will decrease.
  • Rising prices and lower reliability is likely to drive many users back into the arms of the taxi industry thereby achieving exactly the result for which the rules were created.
  • Beijing and Shanghai are the two cities which have the largest non-resident workforce but I suspect that this sort of legislation could easily be used in many of the other large Chinese cities.
  • This creates a very serious problem for Didi as, with its supply of drivers substantially limited in the areas where it has the highest demand, there will be a real crimp on its ability to grow.
  • Furthermore, there remains the very real risk that other major cities in China follow Beijing and Shanghai’s lead causing Didi further agony.
  • If this spreads, it is not inconceivable that Didi’s revenues start going backwards.
  • Didi was originally created as a taxi booking service and one possibility is for Didi to return to its roots.
  • The other is for Didi to move into the high end (where Uber started) and develop a black car offering but I think that demand for this will be quite limited.
  • This leaves Didi’s outlook at the mercy of regulation, which is not what one wants to hear when one has put money into the company at a valuation of $34bn.
  • DJI or Ant Financial are the only two private Chinese unicorns that I would be willing to consider.
  • In the listed sphere I still prefer Baidu and Tencent.

Huawei – Rivers of blood pt. IV

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I am pretty sure Huawei lost money in handsets last year.

  • Huawei reported strong growth in revenues in 2016 but that growth cost it dearly as I think that the handset business lost money as it slashed prices and ramped up spending to gain market share.
  • FY 2016 revenues grew 32% to RMB523bn ($75.1bn) but gross margin fell 114bp to 40.3% and operating margin fell by 205bp to 9.1%.
  • Huawei entered 2016 in a buoyant mood confidently stating that it would become the Number 1 seller of smartphones within 5 years.
  • In line with that goal it massively ramped up spending and cut the prices of its devices in order to close the gap to the global No. 1 smartphone maker: Samsung.
  • Unfortunately, while it was focused on Samsung, Oppo and Vivo really turned on the juice at home, costing Huawei 190bp of local market share in H2 2016.
  • The net result was lower than expected global market share gains for the full year.
  • This was a problem, because Huawei had planned for higher volumes in 2016, meaning that its OPEX budget for the year was too high.
  • Consequently, I am pretty sure that the consumer business entered negative territory which has resulted in a much more measured approach to 2017.
  • RFM research indicates that the focus of 2017 is the generation of profit, which given that Samsung still meaningfully outsells Huawei in terms of volume will require much greater austerity when it comes to OPEX.
  • Huawei is now a comfortable No. 2 in Android but because Android devices are commoditised, that means that I still see it making margins of just 2-4% in the best instance.
  • In order to earn better margin, it must become the No. 1 in terms of volume and outsell its closest rival by a factor of more than 2 to 1.
  • It is this volume advantage that allows Samsung to earn 10-12% margins on Android devices which I think is sustainable for as long as it can maintain that volume advantage.
  • This advantage closed somewhat in Q4 16A but I suspect it will widen once again in Q1 17 as Samsung recovers from the Note 7 disaster.
  • Because of these economics, Huawei has got to do far more than just catch Samsung; it must outsell it by more than 2 to 1.
  • This will be very difficult to achieve which is why I think that Huawei is also working on differentiating its products through software and services.
  • If it can create a good user experience and services that users are prepared to pay something to have access to, then it should be able to make better than commodity margins.
  • However, this is easier said than done and I think that Huawei has a lot of work to do before it will be in this position.
  • This is why, I continue to believe that its best chance of success remains in China where a tie up with Baidu or Tencent could help it plug the service gap it currently has.
  • However, this won’t help in developed markets and here Huawei must do everything that it can to develop the appeal and attractiveness of its Honor brand.
  • This will be difficult given the dominance of the Google ecosystem in these markets but there are cracks in Google’s position that might just give Huawei a chance.
  • In the meantime, I remain unconvinced that Huawei does not have the stomach or the resources to wade through the rivers of red ink that it will take to knock Samsung off its perch.
  • Consequently, I see 2017 as a consolidation year for Huawei, holding share steady and focusing on a return to profit before it considers its next move.
  • I would continue to be wary of any of the Android handset makers whose outlook is increasingly difficult as the market for devices continues to slow.
  • Apple is the only handset maker I would touch at the moment.