Facebook – Empty head

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Another smart speaker that badly needs a brain.

  • It looks like Facebook is joining the ever more crowded smart speaker bandwagon, but without a decent brain inside the box, it may as well be a paperweight.
  • One possibility is for the device to use Cortana as it comes from one of the few companies that doe not compete directly with Facebook: Microsoft.
  • The device looks like it will be using a 15-inch screen from LG and will be manufactured by Pegatron but beyond that there are very few details.
  • I suspect that Facebook may be trying to take a slightly different tack here.
  • This is because:
    • First: the smart speaker market is already very crowded,
    • Second: Facebook has no brain of its own to install in the box,
    • Third: Facebook is more focused on community than smart home.
  • Facebook’s main objective in life is to bring its users closer together using its apps and to give them a sense of community.
  • While this all sounds great for users, the reality is that they will end up spending more time inside Facebook’s fledging ecosystem, generating more traffic and thereby increasing Facebook’s ability to make money from them.
  • Hence, I suspect that this device may be aimed more at making it easier for Facebook friends to spend time with each other by voice, video, messages or even images.
  • However, to earn a place on the increasingly crowded countertop of consumers, it is going to need voice functionality of some description.
  • I think that Facebook M, which is Facebook’s own digital assistant is hopelessly inadequate to fulfil this role, meaning that Facebook will have to get one from somewhere else.
  • Top of my list for this is Cortana which, while not the sharpest tool in the box, it is the only one whose owner is not competing directly with Facebook.
  • In fact, I have seen Microsoft and Facebook creeping closer together (see here) over the last few years and this is a collaboration that could make some sense.
  • With a bit of tinkering on Microsoft’s part, Cortana could be taught how to deal with the majority of the tasks that users ask smart speakers to perform.
  • This work is probably already going as Microsoft may already be working on a smart speaker of its own.
  • Combining this with the screen and Bing would give the device a reasonable shot at doing a decent job of answering queries.
  • This is just another example of how badly Facebook needs to bring its AI up to a level at which it can compete on a level playing field with Google.
  • This would also help Facebook deal with the objectionable content problem that it has on its platform as its current answer to this is to throw more humans at the problem.
  • For me, this has to be Facebook’s number one strategic priority and the progress displayed at F8 on image and video recognition was somewhat encouraging (see here).
  • I am still quite cautious with regards to Facebook’s outlook for this year as I don’t think that either its video offering or its gaming offering are mature enough to bring the company back to high growth in 2017.
  • This combined with requirement to really improve its AI to compete with the other digital ecosystems leads me to still prefer Baidu, Tencent and Microsoft.

Alphabet – Other people’s money

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Core businesses showing signs of maturity.

  • Alphabet reported good Q2 17A results but the fact that it has having to share more of its revenues with third parties is hurting profitability and indicates that growth in its core properties is maturing.
  • Q2 17A revenues-ex TAC / Adj-EPS were $20.9bn / $8.90 below consensus of $21.2bn / $10.34.
  • While I consider the EU fine to be little more than an annoyance (see here), it is the traffic acquisition cost (TAC) where I have concerns.
  • Over the last 12 months, Google has been forced to pay away more of its revenues to its network members and distribution partners.
  • Google network members are now keeping 72% of their turnover compared to 70% a year ago and distribution partners now get 11% of the revenues that Google generates from their devices compared to 9% a year ago.
  • The problem here is that this falls straight to the bottom line and looks to have been entirely responsible for the weakening of margins experienced during the quarter.
  • To a certain degree, what Alphabet is doing is buying growth in revenues and paying for it with lower profitability.
  • This is exactly what Yahoo did much more aggressively prior to its acquisition by Verizon and it was able to mask a decline in its core business by buying in revenues from elsewhere.
  • It implies that monetisation of its own properties and content such as search, mail, maps is starting to hit their capacity ceilings, leaving the company needing to find more growth from third parties.
  • In this regard, the star of the quarter was YouTube which now has 1.5bn MaU with a staggering average engagement time of 60 minutes per day.
  • YouTube is the main home of the alternative media which continues to gain substantial traction across the world as well as the place to go to learn how to do almost anything.
  • YouTube has also seen very high growth of viewing from regular TV screens and is gradually making the move into traditional entertainment.
  • Machine learning and AI are found everywhere in Google’s products and given its lead here, it has the ability to make its services more useful and more intuitive than the competing services of other ecosystems.
  • Hence, I think the outlook remains pretty good for Alphabet but the underlying growth in the core business looks like it is maturing.
  • Hence, profit growth could lag revenue growth as margins come under pressure from increasing TAC leading to more disappointment.
  • I remain pretty cautious on Alphabet overall as the share price has more than kept up with the growth the company has enjoyed over the last 24 months.
  • I still prefer Tencent, Baidu and Microsoft.

Uber vs. everyone – Colonial times

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Uber’s dreams of colonisation are slipping away.

  • First Uber lost China, then Russia and now it looks as if South East Asia may go the same way.
  • I am sure that Brazil and India are taking feverish notes.
  • SoftBank and Didi are investing $2bn investment in Grab, the Singapore-based ride-hailing company that offers its services in 6 countries including Malaysia, Singapore, Indonesia, Thailand, Vietnam and Philippines.
  • The total round is expected to be around $2.5bn with a post money valuation of $6bn.
  • Grab is present on 50m devices with 1.1m drivers and fulfilling 3m rides per day.
  • Grab has two advantages over Uber.
    • First: dominance. According to Grab, it already has 91% market share in taxi hailing and 71% in private vehicle hailing in the markets it serves.
    • This is crucial as RFM’s rule for online marketplaces states that to become to go to place to buy or sell a product or service, the marketplace has to have 60% market share or be double the size of its nearest rival.
    • Assuming these figures are accurate (there was a lot of dispute in China), then Grab has already become to the go to market place although the opportunity is very lowly penetrated.
    • I suspect that this is why it needs such a large fund raising as this position has to be maintained while the ride hailing becomes much more prevalent in the region.
    • Second: GrabPay. One of the problems with ride hailing in emerging markets is the fact that credit card penetration is very low.
    • A large part of the ride-hailing experience is the ease and simplicity of payment and GrabPay is way to bring this experience to those with no credit cards.
    • GrabPay credits can be purchased at ATMs, stores and banks (in a similar way to mobile phone airtime popups) which can then be used to pay for Grab services.
    • I think that this will remove one of the major hurdles to uptake of the service as this issue has made life difficult other offerings like EasyTaxi which operates in Latin America and the Middle East.
  • Uber’s rivals overseas are making the most of its turmoil at home as while management attention is focused in USA, I suspect not much is going on overseas.
  • This gives its rivals more time to establish themselves and none of them appear to be wasting any time.
  • The net result is that Uber’s dreams of colonising the world appear to be slipping away.
  • I suspect that it will remain dominant at home and some key Western markets (like UK) but it will have to do much more than just ride hailing in those markets to justify a $65bn valuation.
  • This is why autonomy may end up being so important as if Uber can capture a large piece of the gigantic $2.7tn transportation market in USA by operating a fleet of autonomous vehicles, then it could conceivably be worth 10x that figure.
  • However, Uber has a very long way to go before it gets to that point as its autonomous offering ranks dead last by RFM’s reckoning (see here) and the car makers could well be fighting in this market for their very existence.
  • I would not be surprised to hear of secondary transactions in Uber stock at well below $65bn and I can’t see much that’s going to push it up anytime soon.
  • One to avoid for now.

Microsoft FQ4 17 – Head in the clouds.

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Not a cloud in the sky.

  • A strong finish to the fiscal year cements Microsoft’s positions as the main alternative to Amazon Web Services and as the preeminent provider of a Digital Work ecosystem.
  • FQ4 17 revenues / Adj-EPS were $24.7bn / $0.75 nicely ahead of consensus at $24.3bn / $0.71.
  • Outperformance was primarily driven by Azure which grew by 97% YoY and Office 365 which showed continued to show healthy progress in both the enterprise and with prosumers.
  • Gross margins improved slightly as favourable product mix was able to offset the impact of the increasing share of revenues coming from the cloud which has much lower gross margin than licence sales.
  • This is entirely normal and RFM research has shown that in Microsoft’s case in the long-run, it is better to have recurring revenues at lower gross margins than one off sales at much higher levels.
  • This is because the one-off sales do not occur frequently enough to generate more profit than subscription revenues at much lower margins.
  • Consequently, gross margins are going to remain under pressure in future albeit at a lower rate as cloud gross margins are rapidly expanding as the businesses continue to scale.
  • Guidance for FQ1 18E was a little light with revenues / EBIT of $24.0bn / $7.1bn forecast compared to consensus at $24.2bn / $7.4bn.
  • Guidance for FY18E remains unchanged with the priorities being placed upon increasing cloud gross margins and cautious growth in OPEX.
  • While the Digital Work ecosystem is going from strength to strength, the consumer ecosystem continues to wither away.
  • The one exception is gaming where the Xbox live community is still growing nicely and Microsoft remains the only real challenger to Sony in console gaming.
  • Despite this, I still think that Xbox Live is a massively under-utilised asset is it has completely failed to get any real traction in mobile gaming.
  • This is why I still think that there may be a party out there that is willing to pay more for Xbox than it is worth to Microsoft.
  • In that instance, Microsoft should sell Xbox in the best interest of its shareholders.
  • Microsoft is not the most exciting company in my universe but it has been one of the steadiest over the last 2 years and there is every sign that this will continue into FQY 18E.
  • Microsoft remains along with Baidu and Tencent, my two top picks.

AR – Productivity pays

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AR is alive and well in the enterprise.

  • Amongst a surprising re-launch of Google Glass and a major pivot by Meta, it is increasingly clear that while augmented reality (AR) makes sense in the enterprise, it is years away from the consumer market.
  • Google has quietly relaunched Google Glass as a smaller unit with upgraded electronics that can attach to a range of regular glasses frames as well as safety eye wear.
  • This time around the focus is 100% on productivity as it has been developed with input from companies and is called Glass Enterprise Edition.
  • The use case being targeted is employees that need to fulfil complicated manual tasks where the device provides instructions obviating the need for assembly instructions.
  • The device is being sold through partners that are offering software customisation on top of the base unit in order to provide the functionally needed by various industry verticals.
  • This is exactly what Atheer Labs moved into some years ago, although its unit also provides communication and is somewhat larger.
  • At the same time Meta, an AR start-up, has also pivoted into the enterprise after realising that it was going to struggle with selling devices to consumers.
  • Meta is now on a major publicity drive with a proposition about how its device can be used to replace office monitors.
  • Interestingly it seems to have abandoned collaboration and communication which is an important part of the workplace and was something it was demonstrating for consumers some years ago.
  • These moves echo how the message from other players like Microsoft and OTG has also changed over the last 12 months with silly living room-based shooting games being replaced with productivity applications.
  • All this is happening because in the enterprise, it is productivity that really matters with the user experience being less important.
  • I think that this happening as in consumer, the users pay money for an experience but in the enterprise users are paid to use the technology.
  • Hence, enterprise users’ willingness to put up with a substandard user experience is much greater.
  • The AR user experience is still miles from where it needs to be but critically it does offer productivity improvements that have led to many companies trialling it particularly for employees in the field.
  • These trials are now gradually moving into real world deployment.
  • Hence, I continue to believe that AR in the enterprise should see both unit shipment growth as well as good growth in revenues from software and services in 2017.
  • However, I think the consumer will continue to languish and the only one that is sticking to its consumer guns is Magic Leap.
  • Magic Leap has made incredibly bold promises around a consumer offering in AR, but it is questionable as to how close it really is in terms of having a working, commercial product (see here).
  • From an investment perspective, AR in the enterprise is the only place I would entertain putting money into this year unless it is something aimed at fixing the limitations that keep AR and VR uninteresting to the consumer.

Baidu – Talking machines.

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The way in China is wide open for Baidu.

  • Baidu’s strategy around its AI platform and its Duer OS has become clearer and with the support of a large number of chip vendors, it is in pole position to be a major player in smart connected devices in China.
  • DuerOS is not a traditional OS like Android or iOS but instead is a much more focused sub-system that is capable of bringing intelligent voice control and intelligence to any device in which it is implemented.
  • DuerOS’s direct comparisons are the software that runs on Amazon’s family of Echo products, Google Home or JD.com’s DingDong.
  • While Duer still speaks no English at all, I think it is currently by far the leading contender in this category for China for two reasons:
    • First: ecosystem. Baidu has already lined up an impressive list of component and device manufacturers who will be implementing DuerOS in their products.
    • Realtek, Intel, Nvidia, MediaTek, RDA, Conexant and ARM have signed up to support the system, which combined with a series of device makers, should create a pretty healthy ecosystem.
    • There are already around 30 products in the pipeline encompassing pretty much the entire range of domestic electronic devices and appliances.
    • Second: Artificial Intelligence. RFM research (see here) has indicated that Baidu’s AI is second only Google and certainly far better than anything else currently on offer in China.
    • This is a product of years of work as well as having developed by far the leading search function in China.
    • The net result is that DuerOS, like Google Assistant, should be able to provide users with the best experience when it comes to understanding and dealing with voice based requests.
  • Putting these two together put Baidu in pole position when it comes to creating an ecosystem within which a whole series of devices can talk and understand both the user and each other as well as work together.
  • This represents a big threat for Xiaomi which has laso built quite a large ecosystem of smart devices but they really lack the intelligence that DuerOS can offer.
  • The upside for Baidu is that by powering all of these voice-enabled gadgets, it will be able to gather data about its users that it will be able to make its search all the more relevant.
  • One of the big differences between China and Western markets is that no one seems to care very much about privacy (see here) meaning that this strategy could work very well.
  • I don’t expect Baidu powered machines to suddenly start spewing out voice-based advertising but learning what its users like and what their needs are will help it make its search results more accurate and hence more valuable to advertisers.
  • Baidu is still the search leader in China but its recent problems with fake advertising are only just behind it and this could provide a good pillar for long term growth.
  • I think that its real rivals, Alibaba, Xiaomi and Tencent, are miles behind when it comes to AI and voice-based services, leaving the Chinese market wide open for Baidu.
  • This combined with its leadership position in AI and search are the main reasons why I still like Baidu together with Tencent and Microsoft.

Uber & Yandex – Russia on top.

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Uber bails from another fight it was not going to win.

  • Yandex and Uber are merging their ride hailing businesses in Russia and surrounding countries but it is clear to me that the real winner here is Yandex that has managed to send Uber home with its tail between its legs.
  • Yandex and Uber have announced that they will create a new company and contribute both cash and their assets to create a company that will offer ride-hailing and associated services (like food delivery) in Russia, Kazakhstan, Azerbaijan, Armenia, Belarus and Georgia.
  • Yandex is contributing $100m while Uber is putting $225 into the new company.
  • Critically, Yandex will own 59.3% of the new company while Uber will own 36.6% with the employees holding 4.1%.
  • The CEO of Yandex.Taxi will become CEO of the new company and I have no doubt that all of the key operational roles will be filled by executives from Yandex.Taxi.
  • The new company has an agreed valuation of $3.73bn after the transaction.
  • The fact that Yandex has ended up with 59% of the company and outright control despite only putting in less than half the money that Uber has put in, indicates that its existing ride hailing business is far stronger than Uber’s.
  • I see this is an almost exact repeat of what happened in China when Uber sold out to Didi and withdrew from the country.
  • I also think that Uber had very little choice as it was competing against the local champion and was only around half of its size.
  • Uber and Yandex.Taxi are market places meaning that to really make money, one has to have 60% market share or be twice the size of the nearest competitor.
  • I suspect that Yandex.Taxi was already almost at that point and that seeing the writing on the wall, Uber took the wise decision to sell out.
  • The net result is that Uber has a 37% stake in a company that will now dominate 5 countries and should be able to show very healthy profitability.
  • This is a much better outcome than the alternative which was holding 100% of a money losing company and being eventually being driven out of business.
  • Uber is currently beset with real problems in addition to the management issues it is facing at home.
  • Russia is the second huge market from which it has been driven which will give competitors in Brazil and India hope that they can do the same.
  • This makes its global domination strategy look somewhat questionable, leaving its real opportunity being to take control of autonomous transportation and creating transport as a service.
  • The problem here is that analysis of autonomous driving data strongly indicates that Uber is by far the worst at autonomous driving (see here), casting doubts over whether it will be able to live up to that ambition.
  • With both of these outcomes looking decidedly shaky and management turmoil, it is not a surprise that Uber investors are feeling somewhat nervous.

 

SoundCloud – Clouds of red

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Management does not have the luxury of choice.

  • Poor monetisation strategy and a lack of fiscal discipline is likely to ensure that SoundCloud ends up being forcibly acquired by one of its rivals when it finally runs out of money.
  • From looking at the contenders, I think Google Music looks like the best fit.
  • Despite raising $70m in debt in March 2017, the company is in dire financial straits and it was forced to close offices and lay off 40% of its workforce last week saving an estimated €16.7m.
  • Given that the company lost around €50m in 2016, this looks set to only prolong the stay of execution until sometime in Q4 2017.
  • The company has said that it wants to take back control of its destiny (from its venture investors presumably) but with no money coming in and great difficulty in raising more, management does not have the luxury of choice.
  • The big question is the user base.
  • SoundCloud last updated this figure 3 years ago when it said that it had 175m MaU but there is concern that the success of Spotify’s free tier and YouTube have taken a big bite out that number.
  • This will have a material impact on any potential acquisition later in the year, but for the moment the main concern remains cash flow or the lack thereof.
  • I see two problems:
    • First: monetisation. Assuming that SoundCloud still has 175m users, it is currently generating $0.02 per user per month in revenues.
    • This compares very poorly to Spotify which I estimate generates $2.54 per user per month despite the majority of its users being on its free tier.
    • The fact that Spotify is 127x better at monetising its users than SoundCloud is, more than accounts for differences in catalogue and user base and shines the light squarely on SoundCloud’s lack of execution.
    • Anecdotally, as a regular SoundCloud listener on its free tier, I have never heard or seen a single advertisement, further reinforcing my opinion on execution.
    • Second: fiscal discipline: SoundCloud has had nice offices in Berlin and elsewhere, has offered free catered lunches twice a week and gifted new employees MacBooks and headphones as well as other freebies.
    • What is more, I think management has had its head in the sand with regard to the financial car crash that has brought it to its current predicament which potentially could have been avoided if it had been faced head-on.
    • The net result of the sudden layoffs is that morale has come crashing down and I understand that the people that SoundCloud badly needs to keep if it is to fix its monetisation problem, are now looking to leave.
  • The biggest problem I see is that the financial problems will absorb much of management’s time in trying to raise more money, meaning that the real problems of the business go unaddressed.
  • Consequently, I think the company will run out of money in Q4 17, as predicted, and be forcibly acquired for just enough to pay down the debt ($70m) leaving the assets unencumbered.
  • Of all the potential suitors, I think Google makes the most sense.
  • This is because SoundCloud is most like YouTube as a repository of user generated content and in that regard, Google will probably be most able to monetise what SoundCloud cannot.
  • I can see it being slotted into the YouTube infrastructure and being rebranded YouTube Audio or something similar.
  • The future is very bleak for SoundCloud but I think that management has only itself to blame for spending too much time feathering its nest and not enough time on grinding out hard cold cash.

 

Snap – Valuation snaps pt. II.

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Twitter remains by far the better choice

  • Reality is beginning to set in for Snap Inc. but I think that the shares still have some distance to go before there is an opportunity to snap up a bargain.
  • A major downgrade by one of its underwriters taking the target price from $28 to just $16 caused the shares to dip to $15.44 which combined with the possibility that Snap Spectacles are not selling that well and savage competition does not bode well.
  • A very informal survey found that the target group (millennials) were not that interested in Snap Spectacles, have not seen them in public and do not know anyone else who is interested in the product.
  • However, there was some interest in Snap’s new functions such as Snap Maps and World Lenses but this is where the competition problem comes to the fore.
  • The minute Snap hits on an innovation that resonates with its user base, Facebook will copy it and offer it to its 1.2bn Messenger users or 600m Instagram users which, in my opinion, pretty much neuters the appeal of Snap.
  • This is because both of these companies are network based businesses where Facebook’s network is orders of magnitude larger and therefore offers its users exponentially more utility.
  • Consequently, I really struggle to see how Snap is going to increase its user base as its differentiation is flagging and the same services on Facebook are more useful.
  • It is on this basis that I value the company.
  • The peer group of Facebook, Twitter and LINE Corp is trading on a forward EV/Sales multiple of 6.6x for 2017E and 5.5x for 2018E.
  • Given, Snap Inc.’s current growth rate and its medium-term potential (see here), I think that the company could conceivably generate revenues of $800m in 2017E and $1.2bn in 2018E.
  • Being generous to Snap Inc. and because it is growing faster than the peer group I can give it a 200% premium to its peers giving an EV valuation of $10.5bn based on 2017E and $13.2bn based on 2018E.
  • The average of these two is $11.9bn with which I can be comfortable assuming flawless execution, continued rapid growth and a move into generating profits.
  • This translates into $12.40 per share which is still some 20% below where the share price is today despite recent falls.
  • Hence, I think that unless Snap Inc. can get its user base really growing again, it is going to have difficulty in justifying it’s still lofty valuation and I see further downside.
  • If Snap were to go below $10 per share ($9.6bn), there could be significant acquisition interest.
  • Until then, I would stay away.
  • Twitter (see here) remains in a much better position than Snap Inc. and if I was forced to choose between the two, I would have Twitter any day of the week.

China Internet – Home court advantage

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Regulatory enforcement makes life even harder for the foreigners. .

  • China appears to be on a path to plugging the leaks in the Golden Shield Project (aka The Great Firewall of China (GFW)) which is likely diminish to almost zero the small presence that Google, Facebook and so on have managed to establish to date.
  • Regulation in China can be a very grey area but when it comes to The Great Firewall of China, the government appears to be deadly serious about enforcing the rules it announced in January 2017.
  • In January the Ministry of Industry and Information Technology (MIIT) announced that all special cable and VPN services need to obtain government approval to operate.
  • This news past without too much fuss as many services such as ride hailing have continued to operate despite being technically illegal.
  • However, over the last few days the MIIT has clamped down further by adding another 84 categories of content to the blocked list as well as demanding that ISPs prevent users from using VPNs by February 2018.
  • I think that it is the demand that ISPs prevent users from using VPNs that has the scope to have the greatest impact.
  • There are two factors to consider:
    • First: there are many VPN providers that are capable of circumventing the GFW but do not have a physical presence in China.
    • Hence, they will be unaffected by the regulation or its enforcement by MIIT.
    • Second: It is much easier to block the vast majority of VPN traffic than most users think.
    • There are two main protocols in use: L2TP/IPsec and Open VPN.
    • Of the two, L2TP/IPsec is used far more because this protocol has been natively implemented into Windows 10, MacOS, iOS and Android which between them account for almost all internet traffic globally.
    • However, L2TP/IPsec has a problem which is that while the traffic is encrypted using IPsec, it is always transmitted on port 500 making it very easy to identify.
    • Open VPN is much more complicated to set up and use but it can be configured to run over almost any port, making it very difficult to detect.
  • Because most users are not technically literate, they tend to use L2TP/IPsec and any ISP determined to block this simply has to block all encrypted traffic on port 500 to shut it down completely.
  • This will leave Open VPN as the only viable option in China and because of the greater complexity in using it, only the very determined users will put the required effort in to get it working.
  • I think that this will further hamper the efforts of the foreign ecosystems to gain a foothold in the domestic Chinese market.
  • However, the flip side is that it will make the entrenched positions of Baidu, Alibaba and Tencent all the more secure as increasingly, they only have to worry about each other.
  • The net result is that my preference for Tencent increases as its position at home will become more secure even as the international market remains wide open for it to address.
  • This is why, it remains my favourite ecosystem from an investment perspective.