Xiaomi – Market timing

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Xiaomi considers a big equity event just as growth peaks again.

  • Xiaomi’s genius for timing is confirmed as talk of an IPO is beginning to ramp up just as its recovery growth rates are about to peak.
  • However, this time around, profitability will be open and clear for all to see and it is here where I think the problems will arise.
  • To be fair to Xiaomi, it has executed extremely well and has been rewarded with a period of very rapid growth as its strategy to distribute through methods other than the Internet and to focus on India has paid off in spades.
  • According to Counterpoint, Xiaomi’s performance really turned around in Q2 17A where YoY growth in smartphone shipments went from -8% in Q1 17A to 59% YoY in Q2 17A.
  • This was a result of three big changes implemented by Xiaomi.
    • First: new products. The new flagship Mi 6 launched at the beginning of the quarter was well received and looks to have been the backbone of the recovery.
    • Second: retail channel. I have long been of the opinion that Xiaomi ground to halt because it had fully exhausted the capacity of selling devices over the internet.
    • In order to address a wider slice of the market, Xiaomi has invested heavily in retail with 123 MI stores opened across China and the first results from this push are now being seen in the numbers.
    • Third: India and overseas: Investments in India are beginning to pay off with the Redmi Note 4 becoming the biggest volume smartphone in Q2 17, elevating Xiaomi to No. 2 in India.
    • By far the largest part of Xiaomi’s overseas fan base is to be found in India and this should help the fan base to grow further.
    • However, India can be one of the most fickle markets as it is so price driven and as many Indian brands have found, success can be all too brief.
  • While growth is clearly back at Xiaomi, the comparisons to the torrid time it had in 2016 are really easy as after Q2 2018, growth is likely to slow substantially as the comparisons to the previous year will become much more challenging.
  • Consequently, sometime in H1 2018 is the perfect time to achieve the best possible IPO price as growth will then be at its highest.
  • However, the big question mark for me is profit, as it is through profit alone that an equity based investment can have any value at all.
  • Here, I am still very cautious as Xiaomi’s strategy is based on providing good quality hardware at a great price.
  • This combined with the fact that it does not have Samsung’s scale in handsets means that it is very unlikely to make more than a commodity margin.
  • When I am as kind as I can be to Xiaomi, I can assume that its smartphone ASP is $270 on 118m units shipped in 2018 with $5.4bn in revenues from smart home products.
  • Assuming an EBIT margin of 5%, this gives me 2018 revenues / EBIT of $37.31bn / $1.87bn implying an EV / Sales multiple of 1.3x and EV / EBIT of 26.7x if the company is valued at $50bn.
  • For an EV / Sales valuation, this is not difficult to reach as Apple is trading on 2018 EV / Sales of 2.7x and Xiaomi is growing faster.
  • However, as I have said above, equity valuation is about profit with revenues being used as proxy when there are no profits.
  • Using EBIT, a very different picture emerges as Apple is trading on 8.4x EV / EBIT and at $50bn, Xiaomi would be on 26.7x.
  • Xiaomi is growing faster than Apple but this is unlikely to last very long and its efforts to build a software ecosystem have been crushed by the BATmen at home and are irrelevant overseas.
  • Hence, it has very little with which to differentiate its wares meaning that it has to compete almost entirely on price.
  • Consequently, the most I would be willing to even remotely consider paying for Xiaomi would be double Apple’s EV / EBIT multiple which would give a valuation of $31.3bn, some 37% below the mooted $50bn.
  • To get to $50bn, Xiaomi would need to put up EBIT margins of at least 8.0% which I think is a stretch given the company’s strategy of selling great hardware at good prices.
  • The advantage of an IPO is that these facts will all be laid bare long before investors have to commit to buying the shares.
  • I suspect that its lack of profitability will keep it from going public until it is capable of putting up much bigger profit numbers.

 

 

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.

 

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.

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.

Microsoft, Huawei & ZTE – Hardware heaven?

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3 big leaps but with potentially with fatal flaws?

  • Microsoft, Huawei and ZTE have both expanded their hardware ambitions but I question whether enough attention to details has been paid to really make these products really successful.

Microsoft Surface Book 2

  • Microsoft has launched a worthy successor to the Surface Book, substantially upping both the power and the size of the device.
  • Two versions are now available: a 13.5” device and a 15” device and on both, the hinge has been meaningfully reinforced to ensure that the screen does not wobble during typing.
  • Microsoft has included the latest Intel processors as well as graphics from Nvidia to ensure that the performance of these devices is top notch.
  • Both screens detach from the keyboard to become a tablet but it is here where my concerns lie.
  • The single biggest fault of the original Surface Book is the fact that when the screen is detached, the keyboard stops working.
  • In my opinion this removes the best use case for a tablet PC which is to turn it into a portable desktop experience. (see here).
  • This provides both a more productive and a much healthier computing experience.
  • One can attach a separate Bluetooth keyboard to the product, but when the user has already paid up for a great keyboard, this seems to be a slap in the face.
  • It is not clear if this functionality has been enabled on the Surface Book 2 but I think it will make the difference between the perfect product and one that continues to follow the obsolete laptop dogma (see here).

ZTE Axon M

  • After being very rapidly commoditised in audio, ZTE is having another go at differentiation with the launch of a dual screen device not very unlike the YotaPhone.
  • The main difference is that ZTE is using two full colour smartphone displays compared to the YotaPhone whose secondary display uses e-ink for an always on display that consumes no power.
  • The aim here is to provide the screen of a tablet in a form factor that can fit in one’s pocket rather than a back-up for when battery is running low.
  • Google Apps can recognise when the second screen is active and run in tablet mode across the two devices but how this works for other apps is unclear.
  • Furthermore, the screen bezels mean that there is a big black line in the middle of the larger display which will be very distracting.
  • I am a big believer in larger screens on pocket sized devices, but until a single screen can unfold or unroll into a large rigid display that is as good as a tablet, this segment is likely to struggle.
  • This has been tried several times in the past and every time the hardware and software compromises being made to get two screens onto a single device have fatally hurt its appeal.
  • I don’t see how the Axon M will be any different and consequently remain cautious on its outlook.

Huawei Mate 10 / 10 Pro.

  • Huawei launched its 2017 flagship products with both devices sporting edge to edge displays pioneered by Samsung and copied by everyone else.
  • The main difference other than slightly different proportions between the devices, is that the Mate 10 is LCD while the 10 Pro uses OLED.
  • However, the main differentiator that Huawei is going for this year is AI where both devices use the Kirin 970 chip, developed in house at HiSilicon which have an onboard neural processing unit (NPU).
  • The idea is that using AI, Huawei claims to be able to prevent the inevitable performance degradation that occurs on all smartphones after months of usage.
  • This aims to compete with Apple’s Bionic A11 chip that also has an NPU but I don’t think NPUs are particularly difficult to produce.
  • AIs work best on processes that are massively parallel which is why GPUs are so good at running AI.
  • This not very difficult to achieve anymore.
  • What is far more difficult, is the creation of the AIs themselves to improve the user experience and here I think Huawei is badly lacking.
  • Huawei has no real AI expertise to speak of and on its own devices it will be competing against the global leader, Google.
  • Consequently, while Huawei may be able to win some short-term differentiation by providing an optimal place to run AIs, this will swiftly be copied leaving Huawei still struggling for differentiation.
  • To really make it, Huawei has to differentiate through the AIs itself and produce algorithms that provide rich and intuitive enhancements to services running on its phones.

OnePlus – Learning curve

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OnePlus’ slip serves as a warning.

  • BBK Electronics is fortunate that OnePlus is one of its marginal brands as a gaffe of this size at Oppo or Vivo could have done real damage.
  • OnePlus is a subsidiary of Oppo which in turn is owned by BBK Electronics (like Vivo) and has its own favour of Android (GMS compliant) called OxygenOS.
  • Unfortunately, OnePlus decided to include code in OxygenOS that captured and uploaded: IMEI, serial number, MAC addresses, IMSI and WiFi network data in addition to which apps were being opened and what the user was doing in those apps.
  • This data was being uploaded and analysed by OnePlus without either the knowledge or consent of its users.
  • OnePlus claims that the data was only being used to improve the user experience but that has not earned the company a free pass.
  • However, once the company had been rumbled it was reasonably quick to react explaining how users can turn off usage data collection but for the other data it stopped short of saying that it would cease collecting it.
  • I suspect the real problem here lies in the cultural difference between China and developed markets.
  • RFM research (see here) has concluded that in China, privacy is much less of an issue where almost all services collect and use data without the user’s permission.
  • Critically, the users do not seem to mind.
  • However, in developed markets, a flagrant disregard for the users’ privacy can sink a product or service.
  • I suspect that the code used in China was simply translated into English and launched into developed markets without a second thought.
  • This is not the first time that this has happened nor, I suspect, will it be the last as smaller Chinese brands try and leave the home market.
  • Fortunately, it appears that this lapse has not also occurred at Oppo which ships a third of its volume overseas (10m units Q2 17) which would be at risk of losing a substantial part of its business as a result.
  • OnePlus is too small for anyone to really notice or care but it serves as a warning to other companies.
  • Being aware of the differences between China and the rest of the world may make the difference between success and failure.

Samsung Q3 17 – Spring clean.

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Now is the best time to clean house.

  • Samsung’s chip business has driven yet another mighty set of results making it the perfect time to deal with all of governance issues that continue to plague the company.
  • Q3 17 revenues and EBIT are expected to be KRW62.0tn / KRW14.5tn slightly ahead of estimates at KRW61.8tn / KRW13.4tn.
  • While these results are not very far ahead of expectations, Samsung has generated 2.8x more EBIT than Intel is expected to have generated in the same period.
  • This will put Samsung’s chip business comfortably in the global No. 1 slot where it looks it is going to stay for some time.
  • Handsets have also had a good quarter driven by its well-received flagship products but the real star of the show remains semiconductors.
  • Typically, an environment of limited supply and strong demand is ruined by over enthusiastic capacity additions but I see the semiconductor industry being a little bit more cautious these days.
  • I think this is due to the prohibitive cost of building a cutting edge fab and the fact that worries regarding Moore’s Law grinding to halt are now firmly on the investment horizon.
  • The big question mark remains China which has said that it wants to create its own semiconductor industry (not including Taiwan) and aggressive roll-outs there could cause yet another demand / supply imbalance.
  • Either way this will take some time meaning that Samsung’s chip business is likely to continue generating vast profits for at least 12-24 months.
  • Against this backdrop, the outlook for the shares remains pretty steady which makes it the perfect time to deal with the corporate governance issues that have been plaguing the company.
  • This appears to have begun in earnest with the resignation of co-Vice Chairman Oh-hyun Kwon who has also been serving as CEO.
  • With Jay Y Lee also likely to out of the picture for a few years, the way is open for new blood to take the helm of Samsung and clean-up these long-standing issues.
  • This is becoming increasingly important as the long-term discount in Samsung’s valuation has evaporated over the last 18 months.
  • This means that the murky way that the company is owned, controlled and managed needs to be changed into something much more transparent.
  • Failure to do this effectively is likely to result in a big correction in the valuation as soon as the current business momentum hits a bump in the road.
  • I am hopeful that today’s resignation is just the first step in this direction and that much more is to follow in the next 12 months.
  • While the company is firing on all cylinders, tolerance to the skeletons as they leave the closet will be at its highest.
  • Samsung’s timing looks to be excellent.

 

 

Apple – Expectations gap.

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iPhone X unlikely to produce the needed super cycle.

  • Expectations for the iPhone X are at fever pitch and I think that a super cycle is now required to prevent a sell-off in the shares.
  • iPhone X is the first substantial revision to the design of the iPhone since the launch of the iPhone 6 and in many ways the circumstances are very similar.
  • In 2014, the biggest complaint with regard to the iPhone was the size of the screen which was considered to be tiny compared to devices being produced by Samsung and the other Android handset makers.
  • When Apple fixed this shortcoming with the iPhone 6/6+, there was a lot of pent up demand as users who could only have a large screen with Android were able to have the best of both worlds.
  • This demand led to shipments growing (calendar quarters): Q4 14 46%YoY, Q1 15 40% YoY, Q2 15 35% YoY, Q3 15 22% YoY and Q4 15 0% YoY.
  • This was followed by shipments declines in Q1-Q3 16 as the pent-up demand was exhausted and replacement rates normalised.
  • I do not think that the iPhone X will stimulate a big enough uptick in replacement rates to meet the expectation that Apple will ship more than 255m+ units in its next fiscal year.
  • This is due to:
    • First, Utility: While the new screen is nice to look at and enables a big screen on a smaller device, it does not offer an increase in utility over the iPhone 7 similar to that of the iPhone 6 compared to the iPhone 5.
    • Consequently, I think it will not create the same degree of desirability and therefore not trigger a similar degree of early replacements compared to the iPhone 6/6+ .
    • Second, Price: The device is meaningfully more expensive starting at $999 which may put some buyers off.
    • Third, Law of large numbers. The bigger Apple becomes, the more difficult it is to post the kind of growth that the valuation of the shares now demands.
  • I think that the iPhone X will stimulate a replacement cycle but one that is smaller in magnitude compared to the iPhone 6.
  • With my optimistic hat on, I can just about get comfortable with the following unit shipment growth (calendar quarters): Q4 17 15% YoY, Q1 18 8% YoY, Q2 18 22% YoY, Q3 18 10% YoY.
  • This gives me 245m units shipped during the next fiscal year which is below current expectations.
  • The net result is that I think expectations for fiscal 2018 need to come back somewhat which is likely to trigger a sell -off in the shares bringing the valuation down somewhat.
  • Hence, I think that the time is right to take some money of the table and put it somewhere else.
  • Tencent, Baidu and Microsoft have less immediate downside in my opinion.

Microsoft – Blue Squares of Death.

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Google is the big winner from Windows Phone’s demise.

  • Microsoft has admitted that Windows 10 on mobile is no longer a focus finally putting to bed any hope (however tiny) that Android handset makers had to escape from Google’s clutches.
  • Their only hope now is that the EU forces Google to make its app store (Google Play) available without having to also install the rest of Google’s ecosystem and set it by default.
  • Microsoft has already wound down the activities that it acquired from Nokia which, combined with barely a mention at developer events like BUILD, has made this fact obvious to everyone but this is the first time that Microsoft has openly admitted this fact.
  • There will continue to be fixes and security patches for a while but no more than that.
  • Microsoft has blamed the lack of availability of apps and services from third parties as the main reason for the platform’s failure, but I have long believed that there was more to it than that.
  • The issue with developers is simply that they won’t develop for a platform with very few users as there is no way to make money.
  • Without third party apps and services, it is difficult to get users to adopt a new platform resulting in a typical chicken and egg problem.
  • Consequently, to kick start a platform, the platform owner needs to prime the pump in order to generate interest that will quickly feed off of itself.
  • Microsoft has tried very hard to incentivise app developers by paying them money and even writing the apps for them but this was not enough.
  • I have long believed (see here) that to succeed Microsoft needed to encourage both developers and users and it was in the encouraging of users where Microsoft really failed.
  • I have long referred to this as the Blue Squares of Death problem.
  • iOS has always been able to sell itself and Android was also a simple sell as it looked just like iOS except that it was cheaper.
  • By contrast, Windows Phone was very different and as a result, Microsoft needed to explain to users why it was great and how they could live their digital lives with Microsoft.
  • Furthermore, devices in the stores needed to be populated with data such that users would be able to clearly see how the Microsoft ecosystem would make their digital lives easy and fun.
  • Without this data, the demonstration devices were simply screens with blue squares on them preventing anyone not in the know to understand the proposition.
  • This needed to be done in conjunction with the efforts to get developers on board in order to give the ecosystem a fighting chance.
  • Microsoft’s mobile ecosystem has always scored reasonably well against the 8 Laws of Robotics and users who did use it generally reported a positive experience.
  • Hence, I believe that it was the failure to educate the users that was the primary reason for the ecosystem’s failure.
  • Marketing has never been Microsoft’s strong point and as a result it simply told users that the ecosystem existed and never explained to them why they should buy it.
  • The net result was that the ecosystem never got enough momentum in order to keep the developers interested resulting in the long decline that we have witnessed.
  • The real loser here is not Microsoft, which is going from strength to strength in the enterprise, but the Android handset makers.
  • If Windows had become a thriving alternative to Android and iOS then they would have had far more leverage over Google which could have resulted in much better economic terms as well as greater freedom.
  • Unfortunately, with its failure, they are completely stuck giving Google a free reign to continue draining the Android industry of its profits.
  • The one exception is Samsung whose profitability I have long believed comes from its huge volume advantage rather than any differentiation it is able to create on Android smartphones.
  • Despite Microsoft’s failure in mobile, its strategy in the enterprise is going from strength to strength leaving me still comfortable with owning the shares.