Android – Downward slope.

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Fragmentation getting worse not better.

  • Despite Google’s best efforts, the situation with fragmentation in Android devices appears to be materially worsening, further reinforcing the need for Google to take Android completely proprietary.
  • Fragmentation in Android comes in two forms:
    • First, vertical fragmentation: this refers to the number of older versions of software that are still active and is exacerbated by a failure to update existing devices to the latest version.
    • Second, horizontal fragmentation: this refers to changes made to Android by different device makers to bring their products to market.
    • This results in a differing and inconsistent levels of performance from one device to another despite running exactly the same version of software.
  • Both vertical and horizontal fragmentation have a substantial and deleterious impact on the user experience and in my opinion are the main reason why the user experience on Android continues to meaningfully lag that on iOS.
  • Analysis by programmer Dan Luu (see here) is the clearest indication yet that instead of getting better, it appears to be getting worse.
  • I had already partially noticed this when I calculated that at the rate at which Android 8.0 is being adopted, it will take 5 years to fully penetrate Google’s own user base (see here) compared to 4 years for other versions.
  • Dann Luu’s analysis is much more granular and his chart clearly shows that for the latest version (far right-hand side), the update trajectory is meaningfully slower than for all of the previous versions.
  • Previous versions have seen a much more rapid update pattern leaving me to conclude that either the number of devices being updated has suddenly declined or that manufacturers have started making new devices using old software.
  • Either way, the effect will be the same which is more devices running older software meaning that Google innovations that require a change in the OS to function, will take at least 5 years to make it into the hands of all its users.
  • This will allow iOS to continue comfortably outperforming Google Android on the RFM Laws of Robotics that test the user experience leaving this as major point of differentiation for Apple.
  • Furthermore, it will also ensure that Google continues to underperform its revenue generation potential on Android devices leading to lower revenues and profits.
  • The more time goes by and the worse this problem becomes, the more I think that the only solution is for Google to take Android fully proprietary and put to bed the fragmentation issue once and for all.
  • This is how Google could begin to see significant revenue upside from its own Google Android devices as well as close the gap to Apple.
  • Its own efforts in hardware are unlikely to have nearly the same impact simply because its volumes are so small.
  • I continue think that Google’s shares remain pretty fairly valued and prefer instead Tencent, Microsoft and Baidu.

Apple – Tick in the box.

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Hacking of Face ID proves its security.

  • The inevitable hacking of Face ID has been achieved but I think that the lengths that the hackers had to go to crack the system proves that, for all practical purposes, it is a worthy upgrade from fingerprint recognition.
  • Vietnamese cyber security firm and Android phone maker, Bkav Corp, has managed to reliably bypass Face ID (see here) by creating a 3D mask of the user’s face with special attention being paid to the eyes, nose and mouth.
  • However, it is pretty clear that a huge amount of work went into the creation of this mask as:
    • First: it was designed using expert cyber security knowledge and an intricate understanding of how Face ID works.
    • Bkav first demonstrated a bypass of facial recognition on laptops in 2008 and has been a player in the field ever since.
    • Second: 3D printing, 2D printing and hand-made artistry was used to create the mask indicating just how intricate the process was.
    • Third: each mask costs $150 to produce.
    • Fourth: it took 9 days to crack (even with at least 10 years’ experience) and I suspect Bkav was working on this flat out.
  • The net result is that Bkav continues to advocate for the fingerprint being the best method of authentication for an electronic device.
  • However, I think that the intricacy and cost of this hack combined with the fact that a detailed 3D scan of the user’s face is required, is actually an endorsement of Face ID as a verification system.
  • Taking this with surveys that suggest that 60% of users prefer the system over fingerprint (9to5 Mac) and the fact that there few reported issues with the reliability and speed of the system leads me to think that Apple has successfully ticked this box.
  • However, fast and reliable Face ID is clearly quite difficult and expensive to achieve (Samsung’s is awful) which leads me to think that Apple has set a standard for high end devices going forward.
  • I think that this will trickle down through the tiers with time, but it looks like fingerprint sensors may have a limited life span.
  • Furthermore, Apple now has a clear point of hardware differentiation over its competitors that is likely to last for a generation or two.
  • In the ecosystem, Apple is still miles ahead largely due to Google’s inability to deal with the endemic fragmentation, security and updating issues that continue to hamper the Android user experience.
  • Hence, I remain unconcerned for Apple’s iPhone gross margins for the next 12 to 18 months.
  • That being said, I think the shares continue to price in a larger iPhone X driven cycle of replacement than I see as likely.
  • This combined with excellent price appreciation so far this year, leaves me indifferent to the shares.

Apple – Augmenting reality.

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Unit launch in 2019 is an augmentation of reality.

  • If Apple is working on an AR headset, I think that there is no way that the technology will be ready in 2019 and that the scale of the technical issues to be surmounted will keep ARKit firmly resident on the iPhone for the foreseeable future.
  • Bloomberg is reporting that Apple is building up a team to develop an AR headset which will be fully vertically integrated from custom silicon all the way up to the apps and the services that run on the unit.
  • I think it makes complete sense for Apple to explore this product area but whether or not this will ever materialise into a real product is very uncertain.
  • This is exactly what happened with project Titan (see here) which was disbanded once Apple realised how difficult and financially damaging it would be for it to make and sell a vehicle.
  • I think that there is an argument to be made that AR has some potential to replace smartphones for consumers, but the technical challenges that need to be overcome are still huge.
  • To make matters worse, there has not been that much progress made against these challenges since I first wrote about them in 2015 (see here).
  • These are:
    • First, size: to be adopted by consumers I think that the unit needs to be no more intrusive than a regular pair of spectacles.
    • I also think that having a light head unit with the computing being executed on a pack that the consumer lugs around with him will not work.
    • I think that everything needs to be in the glasses.
    • Second, field of view: One of the biggest technical challenges of AR is to project the virtual world on top of the real world with a full field of view.
    • This is proving to be a real challenge and almost every implementation to dated uses a huge bulky head unit that produces a letterboxed view of the virtual world.
    • This is a user experience that in my opinion will not be acceptable to the consumer.
    • This is the promise that Magic Leap has made but has yet to live up to.
    • Third, artificial intelligence: to be really useful and fun, the virtual world will need to be aware of where the user is in the real world and of what he can see.
    • This is essentially an AI problem which everyone is feverishly currently working on.
    • At the launch of the iPhone 8, Apple demonstrated image recognition through the phone camera and Facebook has made some progress in this area.
    • However, everyone including Google, is very far from where they need to be to give a computer the contextual awareness that it needs to really make augmented reality work well for the consumer.
    • Fourth, Ecosystem: This is where the smaller companies and Magic Leap are going to fall over (if they haven’t already done so).
    • Just like IoT, TVs, Wearables and Cars, AR is likely to be simply another medium by which to deliver Digital Life services to consumers.
    • Consequently, users are going to want the Digital Life services they enjoy elsewhere to be present on the AR unit necessitating a good cross device offering as well as a vibrant third-party app community.
    • Here, Apple probably has the best chance as its ecosystem on the iPhone remains the strongest currently available.
  • These criteria do not apply to AR in the enterprise (see here) as the nature and economics of the interaction of the user with the unit is completely different.
  • The net result is that while Apple is right to explore the possibilities of AR, I suspect that there is no concrete intention to launch a unit.
  • I see this activity much like the vehicle or the television which were experiments that failed to stand up to the scrutiny of market reality.
  • AR is likely to remain a prisoner on the smartphone for the foreseeable future and not even Magic Leap looks capable of effecting a prison break any time soon.

Razer phone– In character.

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For hardcore fans only.

  • Razer has stuck to what it knows in its in launching first smartphone, but its focus on gamers means that the device looks very dated against competition in its price tier (Galaxy s8, Mate 10 Pro, iPhone 8 etc).
  • The Razer phone sports a very average looking screen with large top and bottom bezels but these make sense in the gaming context.
  • The most annoying thing about playing games on smartphones that are all screen, is that there is nowhere to rest one’s thumbs.
  • The large bezels also provide the real estate to include high specification speakers and Razer is also pushing audio as a differentiator for this product.
  • Razer has provided for this at the expense of aesthetics but combined with a 120hx refresh rate on the display and a snapdragon 835 and a whopping 8GB of RAM, I think it is safe to say that this will provide arguably the best overall gaming experience.
  • True to its roots it also allows gamers to tweak the performance of the device to optimise battery life against performance with the Razer app that comes preinstalled.
  • The Razer phone is effectively a tweaked Nextbit Robin which was the lead product of the small phone maker that Razer acquired in January.
  • This makes sense as it would have been almost impossible to come up with a new design from scratch in such a short time period.
  • Unfortunately, in order to benefit from the 120hz refresh rate, games companies need to include support for it in their apps meaning that the majority of Android games will not be able to make use of this key feature.
  • However, it has announced partnerships with Tencent, Square Enix, Namco and several others meaning that some high-end games will be able to work optimally with the device.
  • Razer has a similar problem to the one that caused Microsoft no end of grief which is that the average consumer will not understand its product and will only see an old looking device at a high price.
  • Consequently, I think that this is an enthusiast device that will only be purchased by users that are already very familiar with Razer and most likely own its products.
  • That being said, I have estimated that the software that it offers on its PCs has between 5m and 10m active users (see here), which probably makes up a big part of its core fan base.
  • If 5-10% of these users buy the device, then this would represent shipments of 500,000 or revenues of around $280m (at my estimated wholesale price).
  • This would help support Razer’s lofty valuation of around 10x sales at IPO, but margins are likely to be very low, leaving me unchanged in my opinion that there will be a better time to consider this one.

Apple FQ4 17 – All things X.

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X hits the spot.

  • Apple reported good results and guided strongly for FQ1 18 as it has managed to deal with some of the production problems with the iPhone X which will result in slightly better than expected shipments in FQ1 18.
  • FQ4 17 revenues / EPS were $52.6bn / $2.07 compared to estimates of $50.7 / $1.87.
  • Slightly soft iPhone 8 demand has been offset by a 25% jump in Mac shipments and a 14% jump in iPad.
  • Both of these products have clearly gained some share as the end markets for PCs and Tablets have remained quite soft.
  • The big problem with the iPhone X has been the facial recognition system where suppliers have struggled to produce enough components to the specification demanded by Apple.
  • I suspect that the slight relaxation of the original security requirement has enabled more of the 3D sensors to meet the grade enabling the slightly better supply underpinning FQ1 18 guidance.
  • As a result, guidance for FQ1 18 was slightly ahead of expectations with revenues / gross margins of $84bn – $87bn / 38.0% – 38.5% forecast compared to expectations of $84bn / 38.5%.
  • The traditional lines outside the stores that were completely absent when the iPhone 8 / 8+ became available, have formed for the availability of the iPhone X leading me to believe that the company is on track for a pretty good replacement cycle.
  • However, I do not think that the iPhone X will offer a cycle nearly as big as the iPhone 6 and my concern is that this is what the market is looking for.
  • In expectation of this super cycle, the valuation of Apple as expanded materially leaving me concerned that much of these heady expectations has already been priced into the stock.
  • Consequently, the valuation argument for Apple is not nearly as strong now as it was 12 months ago, leaving somewhat less inclined to hold the shares for the long-term.
  • I continue to prefer Tencent which has some upside left given its global leadership in Digital Life coverage and Baidu which represents the cheapest way to invest in the trend of AI.
  • Microsoft continues to be steady albeit much less exciting than the other two.

 

Razer – The public game.

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Its too early for Razer to go public.

  • Razer wants to become the ecosystem for gamers but its progress in this area is at such an early stage that I think it has no business being a public company.
  • This is because when a company is in transition, things rarely go to plan meaning that deviations from forecasts on results day are likely to be large resulting in wild swings in the share price.
  • Furthermore, the fact that Razer is listing at $4.5bn, which is more than 10x the revenue that the company is likely to report for 2017, means that any slips or misses will be severely punished.
  • Razer is a PC Gaming hardware company that prides itself on providing PCs and peripherals that cater to exactly what gamers want.
  • On the back of this PC enthusiast niche, it recorded sales in 2016 of $392m upon which it made a reasonable gross margin of 28%.
  • However, just $0.095m (0.2% of turnover) was from software and services which grew to $0.11m (0.6% of turnover) in H1 2017.
  • This tells me that first and foremost, Razer is a hardware company whose best shot at monetising its ecosystem will be through premium device pricing.
  • Apple is the gold standard of hardware monetisation where its gross margins on the iPhone are comfortably over 40%.
  • This means that Razer needs to use software and services to create a user experience that can only be had on Razer products driving increases in prices for Razer products over and above competition.
  • This will be very difficult as:
    • First: virtually all of its products only run software and content created by third parties that is available elsewhere.
    • Second: its ecosystem is almost non-existent today.
    • At the heart of its fledgling ecosystem a is a software platform that launches, aggregates and compares prices of games as well as software that enables LED colour patterns.
    • This software has 35m registered users but the fact that there are only 7.8m likes on Facebook, 2.9m Twitter followers, 1.8m Instagram followers and 1.2m followers on YouTube leads me to think that the active users are somewhere between 5 and 10m.
  • RFM research (see here) has found that in order to hit critical mass, an ecosystem needs to have 100m+ users indicating that Razer has a very long way to go.
  • However, given that gaming is a specific niche within the consumer electronics industry, critical mass for Razer could be substantially lower.
  • Twitch now has well over 100m active users and so if Razer was to achieve somewhere in the realm of 50m, that could be enough to begin ecosystem monetisation in earnest.
  • Razer is also planning to launch a gaming-optimised smartphone which does make some sense as gamers who play games on PCs do also play games (albeit different games) on smartphones and tablets.
  • This has been tried multiple times in the past with no success but gaming does remain the one segment of the Digital Life pie where there is no dominant player in developed markets.
  • As a result, if Razer can create a vibrant and engaged community of gamers on its mobile devices then it could begin to generate device preference which in turn will lead to increases in gross margin.
  • Unfortunately, at a valuation of $4.5bn (around 10x revenues) a lot of this success (which is far from guaranteed) is already being priced into the shares.
  • As a result, any slip (which is quite likely given the transition) is likely to be severely punished by the market meaning that there will probably be a much better time to consider being involved.

Google Pixel – Damage done.

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Software updates won’t fix reputation.

  • The seemingly endless problems with Google’s latest Pixel devices can most probably be completely resolved with software updates, but these will not repair the reputation damage which is likely to keep the few potential buyers that there are at bay.
  • The problems are legion:
    • First, Screen burn in: Because OLED pixels emit their own light (like plasma), they also have the potential to suffer from burn-in.
    • This refers to damage that occurs to pixels where a bright static image has been displayed for too long resulting in a residual ghost image.
    • All OLED screens have the potential to suffer from this problem but through the clever use of software, Samsung has managed to virtually eliminate this problem from its portable devices.
    • Google has no experience with OLED or screen technology in general which has resulted in the bad feedback from users seen.
    • Second, dull colours and blue cast: Since the device made it into the hands of users there have been complaints that Pixel’s OLED is dull with an odd blue cast compared to those in Samsung devices.
    • Third, clicking sounds: There have been numerous reports of clicking sounds coming from the device which is caused by the activation of the NFC receiver.
    • Fourth, audio quality: Some of the recordings that the device makes appear to play back with very poor audio quality.
  • These problems are all surmountable and look to me to have been mostly caused by a lack of hardware experience and the rush to bring the device to market.
  • Consequently, there is a massive software update that Google says will address all of these issues but I think that will not fix the biggest issue of all.
  • This is the damage that has been done to Google’s reputation for building good quality hardware.
  • At the price that Google is charging for its smartphones, there is no real margin for error as it is competing head on with Samsung’s flagships and iPhone 8.
  • I suspect that the end result will be that the Pixel 2 ships much lower volume than it would otherwise have done as there are plenty of very high-quality alternatives.
  • This will put yet another crimp on Google’s ambition to become more vertically integrated and it appears that the best way to get the most value from Google services is still to use them on another device.
  • It comes as no surprise to me that Google continues to generate more revenue per device from iOS than Android.
  • I think what it really needs to work on is fixing the Android user experience on all of the other devices out there as this is how it can close the gap on iOS which could have a significant upward impact on revenues.
  • Until then, I think Google will continue to underperform its Android potential leaving me pretty indifferent to an investment in the shares.

Snap – Reality of fad.

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Snap learns a hard lesson.

  • Snap generated plenty of interest around its first hardware product but the fact that more than 50% users wore the spectacles for just 4 weeks indicates that the device was nothing more than a passing fad.
  • To add insult to injury a sizeable number of users got fed up with the glasses after just one week.
  • Snap sold around 150,000 units of the spectacles which was above its initial 100,000 target but the interest that it managed to generate in the first few days fooled it into thinking that it was something more than a fad.
  • When Snap launched the spectacles, it announced that vending machines would pop-up at undisclosed locations a clever strategy that generated long queues to purchase the product.
  • Unfortunately, this development led the hardware-inexperienced Snap to think that it had a hit product on its hands which meant that it ramped up manufacturing orders in anticipation of demand which was never real.
  • Snap has declined to disclose how large its inventories are, but it did say that as of Q2 17, it had irrevocable hardware purchase commitments of $29m related to the spectacles.
  • This will be on top of the inventory that the company already has.
  • I suspect that following launch, the company ramped up its orders to around 500,000 units which assuming 150,000 sold and a bill of materials of $110, would give an unsold inventory of 350,000 units with a total cost of $38.5m.
  • Snap has plenty of cash on its balance sheet ($2.8bn) and so writing down this inventory to $0 will not hurt financially but it is a real black eye for the company’s credibility.
  • Snap has also substantially reduced its resource commitment to hardware which I think spells the end of its efforts to compete in hardware (see here).
  • I have long held the opinion that Snap has no business being a hardware company (which would materially damage its valuation) and should instead concentrate on its core strengths.
  • These strengths are working out innovative ways for users to engage with each other over an instant messaging platform but unfortunately these innovations are very easy to legally copy.
  • Instagram now has a successful habit of copying all of Snap’s best innovations and pushing them out to its much larger user base pretty quickly.
  • This makes it extremely hard for Snap to compete as apps that offer communication are all about the network of users.
  • Metcalf’s Law of Networking states that the utility or value of a network increases by the square of the number of devices attached to it.
  • This would imply that Instagram (4x Snap’s size) should be at least 16x more valuable than Snap meaning that at Snap’s valuation, Instagram makes up more than half of the valuation of Facebook.
  • Instagram is an important part of Facebook, but I don’t think it is contributing more than 50% of Facebook’s value.
  • Hence, I would be inclined to believe that Snap remains meaningfully over-valued.
  • I think that fair value for Snap remains around $12.40 per share which is still 18% below where the shares are today.
  • I still think that negative sentiment could push the shares closer to $10 at which point acquirors could start to take interest.
  • Until then I still see no reason to get involved and would strongly prefer Twitter to Snap Inc.

Google & Amazon – Battle for the home pt. VI

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Opportunities to break in are fast disappearing

  • Google seems to be closing on in launching a Google Home based product with a touchscreen which indicates that Google’s understanding of the smart home user experience is improving quickly.
  • This is bad news for others like Essential (see here) that are looking to compete in this space as both Google and Amazon are starting to make progress on addressing the areas where they have been weak in the smart home.
  • If Google can now improve its position with the developers of smart home products, it will be in a good position to really take the fight to Amazon which still dominates with over 70% share.
  • Earlier this year I identified two major problems with using voice-based digital assistants in the home.
  • These were:
    • First, voice control: RFM research (see here) has found that voice communication with machines is very far from being good enough to work effectively without a screen for output.
    • The issue is that even the best machines are not yet intelligent enough to provide a useful experience using voice-only and often have to fall back to a screen.
    • In Google Assistant’s and Alexa’s case has meant using the screen of a smartphone which is not an optimal experience especially as most voice usage occurs when the hands are busy doing something else.
    • At launch Essential Products had taken this into consideration as its small device (Essential Home) has an attractive looking screen on the top.
    • This looks much better than hideous Amazon Show which seems to have been designed to be a jack-of-all-trades (master of none).
    • I think that Essential hit the nail on the head and its product should optimally fix the single biggest current problem with human machine voice interaction with its integrated screen.
    • However, should Google come up with an attractive take on Google Home but with a screen, I think this will lessen the appeal of Essential Home materially.
    • Second, fragmentation: Despite Amazon Alexa being able to talk to almost everything, the experience has been horribly fragmented.
    • Google Home has been no better and has also suffered from their being fewer compatible devices.
    • The real use case for the smart home is where all elements in the home are aware of each other and can be controlled together.
    • For example, the use should be able to say “I am going to bed” resulting in the doors locking, blinds drawn, heating turned down and so on.
    • Instead each separate device has had to be manually operated and adjusted.
    • With each launching a service called “routines” (see here and here) both Google and Amazon have moved to start addressing this issue.
    • How well these “routines” work remains to be seen but critically, both companies have recognised the biggest problems with their services and are moving to address them.
  • The net result is that the opportunities for small differentiated services to break into this space by doing something better is closing fast.
  • This combined with the fact that developers will be making their devices work with Amazon first (and maybe Google) will make it even more difficult for smaller players to break-in.
  • Market penetration remains very low which means there is still a chance, but new entrants need to act fast as the big players are moving much more quickly than their size would indicate.

Essential Products – Long road home.

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Home is where the heart is.

  • Essential Products is clearly struggling with its Essential Phone which I think will probably lead to it ending up focusing on the smart home only.
  • Essential Products Inc. has used the only competitive weapon it ever really had and has cut the price of its flagship Essential smartphone by 29% from $699 to $499.
  • Those that have already purchased the device will get a $200 credit towards purchasing other devices within the Essential ecosystem such as the 360 camera.
  • There are two major problems with this move:
    • First: it will really annoy fans of the device who paid full price and
    • Second: it is an admission that there is nothing particularly special about this device leaving Essential Products in the same boat as everyone else in terms of competing on price.
  • I see this as a real climb down for the company because competing directly with the Chinese and LG directly on price, it means that the user experience and ecosystem that it spent so much time creating is getting no traction with users.
  • This fits exactly with my previous observation that Essential Products has created a great Google phone and nothing more (see here).
  • Essential’s strategy is to create an ecosystem of products and services around its smartphone that reach into smartphone peripherals and the smart home.
  • In the smart home, I think Essential has a good grasp of the real problems and has designed a product to address these issues (see here) but digital ecosystems are still completely defined by the experience on the smartphone.
  • Essential aims to differentiate in hardware, AI and the cross-device compatibility and consequently to get its innovations in the hands of users, it thinks that it needs a smartphone.
  • The aim with the price cut is obviously to drive volume and user numbers but I suspect that this will put real pressure on its gross margins meaning that the $300m recently raised by the company will erode much more quickly.
  • Furthermore, this action will almost certainly result in a hit to the company’s credibility as it makes much of the message it communicated at the time of launch look hollow.
  • I continue to think that the company has no differentiation in smartphones but its strategy in the smart home looks interesting (see here).
  • Consequently, I can see the smartphone being dropped with all the remaining focus and resources being placed on creating a position in the smart home.
  • This will be easier and said than done as it is up against two companies that sell good products at cheap prices and have both the means and the will to lose money for a sustained period to build the market position they are looking for.
  • Against this, Essential Products has little chance but its hope lies in its understanding of the smart home and moving to address it ways that its opponents are currently failing to do.
  • It has to move fast as both Amazon and Google are showing signs of realizing what it is they are missing in the smart home.