Smartphone hardware – Sticky fingers.

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Fingerprint sensors define the market this year.

  • The problem with covering the whole of the front of a smartphone with glass is that it creates a problem for fingerprint ID on the home button.
  • Samsung got around this by inconveniently locating fingerprint ID on the back of the device ensuring that it gets used much less than it otherwise would.
  • Another option is to put the fingerprint ID sensor on the power button which can be used to turn the screen on.
  • I think that this is currently the lead contender for the iPhone 8 as I have seen no indication that Apple has cracked the problem of putting the sensor under thick protective glass and still have it working reliably.
  • Qualcomm has just announced a solution that uses ultrasound that is capable of reading a fingerprint beneath an OLED display with a thickness up to 1.2mm as well as up to 0.8mm of glass.
  • Assuming the sensor is reliable, this specification should be more than enough to offer fingerprint recognition on any smartphone regardless of whether it uses the Snapdragon chipset.
  • Qualcomm is demonstrating the technology on a retrofitted Vivo smartphone and I suspect that Vivo will be the first to deploy it in a commercial device.
  • Apple and Samsung are working on their own solutions but I do not believe that they have solved the problems created by placing the sensor under the glass.
  • Fingerprint sensors have become part of everyday life on smartphones and with Samsung, Xiaomi and Essential Products setting the standard when it comes to screens, Apple has little choice but to follow.
  • Hence, with the upper and lower bezels of the device being no longer available, by far the best solution remains to place it under the screen on the virtual home button.
  • I think that anything else, including the power button, diminishes its usability and therefor its overall appeal.
  • Fortunately for Apple, the draw of its ecosystem is still very strong meaning that even if the sensor is on the power button or even the back, it is unlikely to meaningfully impact demand for the device.
  • This is because despite improvements, the user experience on Android remains meaningfully adrift of that on iOS which is so far keeping users very loyal to iOS.
  • Hence, I don’t see Apple rolling out this technology until it is rock solid in terms of reliability.
  • I think that the availability of under screen fingerprint sensors will have a significant impact on the handset market in Q4 17 as they enable an optimal user experience.
  • Anyone who can bring this to market by Q4 17 is likely to enjoy a temporary gain in market share, most likely over Samsung, but even the Qualcomm solution will not really be available until next year.
  • Consequently, I see Q4 17 continuing to be dominated by Samsung and Apple once again.
  • Samsung’s shares continue to be very strong, but I think that the valuation opportunity has now passed.
  • Consequently, I still prefer Tencent, Baidu and Microsoft.

Alphabet vs. EU – Timeslip

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Google has time on its side in Android.

  • I think that it is the remedies that the EU imposes that have the potential to do the real damage as long as they are quickly put in place.
  • I view the fine as almost an irrelevance.
  • Alphabet has been handed a $2.7bn fine by the EU as punishment for what the EU considers to be anti-competitive practices in using search results to promote its own shopping services over those of competitors.
  • This fine amounts to just 23 days of net cash flow from operations for Alphabet, causing only a small ripple in what is otherwise a powerhouse of cash generation.
  • Google has 90 days to change its algorithm to bring search results into line with what the EU considers to be fair or suffer a further fine equivalent to 5% of daily global revenues ($14m) for every day that the algorithm continues to breach the EU ruling.
  • Google clearly intends to appeal the ruling but I am doubtful whether it has a realistic chance of changing the outcome.
  • This is but one of three current complaints being made against Google with the Android and AdSense complaints yet to be addressed.
  • Of the other two, I think that the Android complaint has the scope to do the most damage.
  • Again, this is not because of a fine that could be even bigger than this one, but because of the possibility that the EU forces Google to unbundle Google Play from the rest of its Digital Life services.
  • This “bundling” is laid out in the Mobile Application Distribution Agreement (MADA) that each handset maker has to sign in order to get access to Google Play.
  • This agreement requires handset makers to install certain Google services on the device at the factory, set them as the default service as well as to put a search bar on the home screen.
  • It is well known that it is almost impossible to sell an Android device in developed markets that does not have Google Play on it meaning that every Android device in developed markets is effectively a Google ecosystem device.
  • Google’s position is that it is “entirely voluntary” for handset makers to sign the MADA which I believe is a very misleading statement.
  • This is because if handset makers do not sign the MADA, they are unlikely to be able to sell their devices in good volumes in developed markets.
  • This is why I believe that while the MADA is entirely voluntary technically, it is effectively mandatory because there will be no meaningful handset sales without it.
  • I don’t think for one moment that the EU will be fooled by the “entirely voluntary” defence which is why Google needs to come up with a far more robust defence for its conduct in Android.
  • If Google was forced to unbundle Google Play from its other Digital Life services, handset makers and operators would be free to set whatever they like by default potentially triggering a decline in the usage of Google’s services.
  • However, one thing that Google has in its favour is time, as these proceedings can take years to be resolved.
  • The longer it takes, the more time that Google will have to become entrenched with users before it is forced to unbundle Google Play from its other services.
  • By that time, if Android users are already hooked on Google’s services, the need to have the MADA will be diminished as users will simply download the services to which they have become accustomed from the app store.
  • Hence, the longer the process takes, the less teeth the remedy will have.
  • The caveat to this is the power of default and the example set by Apple Maps and Internet Explorer.
  • Apple Maps is an inferior service compared to both Google Maps and HERE but it has managed to gain traction in iOS by being set as default with no option for the user to change it.
  • Internet Explorer’s market share has been gradually eroded over a period of many years since Microsoft was forced to unbundle it from Windows.
  • Consequently, I think that there is still a possibility that Google loses its entrenched position with users if the EU forces it to relax the MADA requirement, but it could take a long time.
  • Alphabet’s share price has barely reacted to this news and at $955, I still find it to be unattractive preferring instead, Tencent, Microsoft and Baidu.

Essential Products – Domestic bliss.

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Home is where the heart is

  • While I am not a fan of Essential Products’ phone (see here), I think that the strategy around the smart home is bang on I think it has created the right product.
  • I don’t like the phone simply because it does not do anything particularly special in a brutal commodity market and given the company’s overall strategy, I see no real need why it can’t make use of the phones of others.
  • However, the Home product is something else, and although it may not succeed, I think that it has a good chance.
  • This is because, I think Home has been designed to explicitly address the two biggest problems with home automation that exist today.
  • These are:
    • Firstly, 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 this means using the screen of the phone which is not an optimal experience especially as most voice usage is when the hands are busy doing something else.
    • Essential Home has already taken this into consideration and the small device 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.
    • I think that Essential has hit the nail on the head and its product should optimally fix the single biggest current problem with human machine voice interaction.
    • Second, fragmentation: Despite Amazon Alexa being able to talk to almost everything, the experience remains horribly fragmented.
    • The real use case for the smart home is where all elements of 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 to be manually operated and adjusted.
    • The experience on Alexa is so bad that it is quicker and more convenient to make these adjustments by hand.
    • Apple HomeKit also addresses this problem effectively but I see little traction among the smaller, more innovative smart home device creators.
    • Furthermore by being limited to Apple products only, 85%+ of the market is not being addressed.
    • This is the problem that Essential has recognised and is trying to address this by making its Home APIs and Ambient OS as open as possible.
  • I like the potential of this product as it is both differentiated from its competition and has been designed to explicitly solve the biggest problems with home automation.
  • There has been no word as to what assistant will be resident in the device, but if Essential is smart, it will ensure that the user can use any assistant he chooses.
  • The problem is going to be getting the device into the hands of users in volume.
  • This will be critical because volume deployments will be needed to get developers to make their products work on Ambient OS.
  • This is the old chicken and egg problem which is very difficult to crack but once it is solved creates real momentum for a platform.
  • This is the problem that Amazon cracked earlier this year and now every developer of any smart product will make it work with Alexa.
  • This will be the key to getting the Home product to succeed but it is going to be an uphill battle even for a start-up as well financed as Essential Products Inc.

Amazon – A song of ice and fire.

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Project ice has nothing to do with phones.

  • After racking up nearly $1bn in losses from its last foray into handsets, one would think that Amazon would have had enough but it appears that it is at it again but for a totally different reason: India.
  • Project ice appears to be the development of another Android device but this time at the other end of the price spectrum.
  • One of the devices in the pipeline features a 5” to 5.5” screen with 2GB RAM, 16GB of storage, Snapdragon 435 and a cracking price to match at around $93.
  • The device is fully Google compliant with its ecosystem installed and set by default but I am pretty sure that at least Amazon’s core e-commerce apps will also be installed.
  • Amazon’s last set of results (see here) showed a big dent in profitability in its overseas operations that I think can be largely put down to its determination not to lose India as it lost China.
  • Alibaba wiped the floor with Amazon (and Walmart) in China and with developed markets maturing, Amazon’s long-term growth is at least partially dependent on history not repeating itself in India.
  • In the Indian market, Amazon is the underdog with around 23% market share compared to Flipkart on 35% and Snapdeal on 15%.
  • However, it is by far the best financed and if it comes to last-man-standing battle, it is likely to win.
  • However, Softbank, the backer of Flipkart is keen for it to merge with Snapdeal which if perfectly executed, would give the combined entity 50% share (see here).
  • According to RFM’s rule that to become the go to place to transact, a marketplace must have at least 60% market share or be at least double the size of its nearest rival (see here).
  • The combination could be enough to see off Amazon but never to back down from a fight, Amazon has a trick up its sleeve.
  • I have long believed that the internet in India has very little to do with fixed (like developed markets) and everything to do with mobile (like China).
  • Consequently, the ice device portfolio could serve as a way to encourage users to do their online shopping with Amazon rather than Flipkart & co.
  • Google has no e-commerce offering to speak of and so Amazon can produce Google ecosystem devices (which Indian users demand) and at the same time install its shopping apps, optimise them and set them by default.
  • Studies have shown time and again that having apps preinstalled leads to them working better and being used more, even if they are not as good as other apps that need to be downloaded (e.g. Apple Maps).
  • Hence, I can see Amazon selling ice devices at 0% gross margins in order to win over more affluent Indian users to its shopping proposition at the expense of Flipkart & co.
  • This is exactly the strategy that it uses with Fire tablets and Kindle with the money being made on the content sold over the device.
  • This example looks no different except that the strategy here is to gain share in e-commerce before Flipkart can reach an unassailable position through consolidation.
  • This is why Flipkart has to act promptly to consolidate Snapdeal as the longer it delays, the more share Amazon is likely to gain and the harder it will be to become twice Amazon’s size.
  • Amazon’s strategy to control the primary device, from which Indians will do their online shopping, only increases the urgency for it to act and act fast.
  • Winter is coming.

WWDC 2017 – Catch-up gems.

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Mostly catch up but studded with a few gems.

  • While Apple spent most its time catching up with innovations made by other ecosystems, there were a few areas where its announcements put it ahead of the pack.
  • Machine Learning
    • Apple is weaving machine learning into all of its services.
    • This combined with increasing integration of Apple’s own apps and services promises to enhance the user experience.
    • This includes new predictive faces (like Google Now) on the Apple Watch and photo recognition and organisation and smart responses predicted from the user’s history in other apps.
    • The demos were slick and effective but how well this will work in the field and with a user that does not use all of Apple’s Digital Life services remains to be seen.
    • Apple is working hard on AI but I think it still remains way behind Google, Baidu, Yandex and even Microsoft.
  • iOS 11
    • For the iPhone, iOS11 is an incremental update but one that focuses most attention on iMessage and the App Store.
    • Apple, is following Tencent in allowing users to do more and more with iMessage including the enablement of peer to peer payments using Apple Pay.
    • iMessage and Photos are the only two services that really got some attention this year leading me to think that these are the two areas where Apple is really trying to create stickiness.
    • This is particularly relevant as I observed yesterday (see here) that leaving iOS for Android was particularly easy as I don’t use iMessage.
    • The network effect can be particularly strong leading me to think that iMessage is now one of the most important services that Apple has.
    • I think that it is much more important than photos as Google Photos is just as good and makes it easy to move photos off iOS.
    • The App Store update aims to address the problem created by its own success which is that discovery of new apps and services is now pretty difficult.
    • New tabs aimed that highlight the new and cool stuff as well as give tips on existing apps is curated through the user’s history and aims to drive more purchases.
    • The aim is clearly to further distance itself from the humdrum experience of Google Play.
    • App Store is an area where Apple is extending its lead.
  • iOS 11 for iPad
    • However, it was for the iPad that the new iOS software really shines.
    • In conjunction with a solid update to the line, iOS 11 enables new functionality that takes the iPad even closer to the laptop.
    • The iPad now has a file system which combined with enhancements to multitasking and window management take its usefulness to a new level.
    • This includes the ability to drag and drop links, pictures and files from one place to another and to share them in multiple ways more easily.
    • This takes the iPad (particularly the pro) closer to a laptop in terms of functionality but it does still fall short.
    • Without support for a mouse and full fat office, the iPad cannot replace a laptop for most content creators although it is getting closer all the time.
  • Hardware
    • In addition to the iPad Pro, the iMac and MacBook Pro all received incremental updates that keeps them in line with the high end of the PC market.
    • Apple also launched a super high end iMac Pro all in one aimed at the professional who needs to spend more than $5000 on a computer.
  • HomePod
    • Apple also gave a sneak peak of a home speaker that aims to replace expensive WiFi Speakers but also has the functionality of Amazon Echo and Google Home.
    • This is a high-end speaker that sports features that are designed to produce excellent sound quality and functionality potentially rendering Sonos obsolete.
    • At the same time the HomePod has Siri embedded meaning that it can answer questions and control the smart home through HomeKit.
    • Apple has positioned this as something that the user buys for a high-quality audio experience with Siri coming as an added bonus.
    • This is a smart move because Siri is not that bright and is easily out performed by Google Assistant while being on a par with Amazon’s Alexa.
    • HomePod shows no sign of being open to developers other than through HomeKit and I was disappointed that Spotify and other music services have not been enabled on the device.
    • Hence, this a device for the Apple Music subscribers of which there are now 27m and not really for anyone else.
  • The net result is that while I think there are some very interesting moves being made around the productivity elements on the iPad, Apple is mostly keeping step with the competition.
  • The good news is that its edge as the best distributor of apps and services of third partied has yet to be matched by Google, giving it time to re-invent its hardware differentiation.
  • The valuation case in Apple is not nearly as strong as it was 6 months ago leaving me still preferring Microsoft, Baidu and Tencent.

Essential Products – Not essential.

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Andy Rubin still works for Google. 

  • Essential Products Inc has launched a series of products aimed at creating an ecosystem but none of them do anything or enable anything that is desperately new.
  • Consequently, the real beneficiary from another nice looking, easy to use phone will be Google whose ecosystem will be front and centre of the flagship device.
  • Essential Products Inc. was founded by Android creator Andy Rubin and has launched two devices and two accessories in a bid to stitch together the fragmented smart home space.


  • The Phone is similar to the Galaxy s8 although its screen is lower resolution, not waterproof and the battery has a slightly lower capacity.
  • Its one major area of differentiation is that the chassis is made from injected Titanium and has a ceramic back, potentially making it much more resistant to being dropped and scratched.
  • When it comes to screen protection, both are using Gorilla Glass 5 meaning that resistance to screen smashing should be about the same.
  • It also has two pins on the back (much like the Moto Mods concept) to which accessories can be attached.
  • The API for the accessory pins will be made available to developers to create their own devices to attach to the phone.
  • However, it has the price to match at $699 compared to $750 for the Galaxy s8 which is where I think the trouble will begin.
  • Phone is nice looking but I can’t see how it does anything that is not already available and outside of chassis resistance, Samsung gives more hardware bang for the buck.


  • Essential products has also launched a voice activated home controller that aims to bring the smart home together in one place.
  • This is something that the smart home badly needs as the Alexa user experience is dire and hardly any products and services work with Google Home.
  • This product is different for two main reasons:
    • First: it is not designed to play music unlike other offerings although it does has a small speaker like the Echo Dot.
    • Instead, it is aimed at bringing all of the home’s devices together into a single place to manage them in an easy and fun to use way.
    • This device is also able to integrate these products such that smart devices can work together in new, fun and potentially very useful ways.
    • For example, when the timer goes off, the room’s lights can be flashed on and off rather than the generic alarm bell sound that everyone else uses.
    • Second: Home has a small screen on the top that is designed to enhance communication and interaction with the user.
    • 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.
    • Consequently, this configuration makes a lot of sense.
  • The device runs its own OS called Ambient OS but Essential intends to open this up completely such that anyone can write functionality for the product.
  • This device takes a massive risk because 70% of the usage of devices in this category is as a Bluetooth speaker.
  • Consequently, there is a sizeable risk that this device will not appeal to the majority of users looking to buy something in this category.
  • Another big issue is the source of the AI that will be running Home as this will be the heart and soul of this product and the AI in Ambient OS currently looks as dubious as Bixby (see here).


  • Essential products has launched a charging plate for the Phone that connects through the two pins as well as a 360 degree camera.
  • I think that the charging plate is pretty useless as wireless charging is starting to come of age and inclusion of one of the standards in the device would have enabled a good user experience with products already present in the market and in users’ hands.
  • For example, because the Galaxy S8 supports Qi charging it will work with any compatible pad.

Take Home Message.

  • When I originally wrote on Essential Products (see here), my view was that it needed to produce must have devices and in that regard, I think it has failed.
  • The Phone is a Google Ecosystem device with a few nice features but less bells and whistles than the Samsung Galaxy S8 for almost the same price.
  • The Home has the most potential but it is taking an awful risk in that it is not addressing by far the biggest use case and has dubious AI.
  • It will also be dependent on third party developers meaning that it will need volume but even in its best case it is not going to out-ship Google Assistant or Amazon Alexa.
  • Consequently, I remain unconvinced with regards to what is special and different about Essential Products and suspect that many consumer electronics buyers will feel the same way.
  • Differentiation in hardware is extremely difficult meaning that Andy Rubin needs to have some software tricks up his sleeve that he is yet to show.
  • Failing that, it seems that this company will end up enriching Google more than itself.

Android Project Treble – Yellow brick road

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Yellow brick road that leads to a fully proprietary Android OS.

  • The launch of Project Treble sees Google finally moving to address the Android updating problem but it also quietly paves the way for Google to take full control of the Android software.
  • It could also cost the handset makers more of the precious little differentiation they have left.
  • I have long believed that the inability to update Android OS is one of the biggest problems that Google faces with its ecosystem on Android (see here).
  • This has meant that whenever Google makes an innovation that requires any changes to be made to the OS, it takes around 4 years to arrive on the majority of Google ecosystem Android devices.
  • In contrast iOS takes a matter of weeks to update almost everybody.
  • For example, as of today, despite being available for over 6 months, less than 7% of all Google ecosystem Android devices are running the latest version (7.0 Nougat).
  • This is because Google has no control over the updating process for all of its devices (except Pixel and Nexis) and must rely on handset makers and operators to do it.
  • The problem here is that handset makers have little incentive to make their devices updatable and most of the time are quite content just to sell a new handset instead.
  • Project Treble aims to fix this by abstracting the hardware vendor’s modifications from the underlying OS such that the OS can be updated independently.
  • The way it works today is that Google passes the code to semiconductor companies who modify the code to ensure it works with their chips and release it to the handset makers in the form of a board support package (BSP).
  • The handset makers take the BSP and then modify it to meet their own requirements such as functionality or new hardware.
  • It is at this point that their modifications must pass the compatibility test suite (CTS) in order to able to deploy Google’s App store: Google Play.
  • Problems begin when Google updates Android OS as the manufacturer has to ensure that all of the modifications it has made will work before distributing the new Android code to its devices in the hands of users.
  • This process can be so arduous that many handset makers simply do not have the resources or the incentive to redo their modifications meaning that the update stays on the shelf.
  • Project Treble aims to fix this by adding in an abstraction layer between the Android OS and the vendor modifications such that the underlying Android OS can be updated without the manufacturer losing compatibility.
  • This is being referred to at the Vendor Test Suite (VTS) and while it looks like a great idea, it will have a number of problems.
    • First, differentiation: Most Android handset makers differentiate themselves through hardware innovation.
    • For example, Samsung’s iris scanner and HTC’s edge sensors on the U11.
    • This sort of differentiation may require the handset maker to put changes into the Android OS that go beyond the VTS interface that Google has defined.
    • Modifications beyond the interface obviate the whole point of the VTS and so Google updates would be back to square 1.
    • Second, control: The VTS will be like the computability test suite (CTS) which is a series of tests that the software must pass in order to ensure that apps from Google Play will run properly.
    • Modifications made beyond the interface are likely to result in a failure to pass the VTS test.
    • Hence, in effect, the VTS is another level of control as I suspect that handset makers that don’t pass the VTS will not be able to use Google Play or Google services.
  • Hence, the VTS could further limit the small amount of differentiation that the handset makers have left, further increasing their commoditisation.
  • However, for Google its all good as handset makers will no longer have any excuse not to update the Android OS, thereby ensuring that Google’s innovations in the OS come to market much more quickly.
  • However, this does nothing to address the fact that a large number of handsets are not updateable which has been discussed here.
  • This also paves the way for Google to:
    • First: take control of updating the Android OS separately from any modifications that the handset makers have made.
    • Second: move the remaining parts of Android OS out of open source and into Google Mobile Services (GMS).
  • It has long been my opinion (see here) that this is what Google must do to fix the inherent problems of fragmentation and software updating that continue to plague the platform to this day.
  • An easier to use and more consistent platform would most likely increase traffic generation and therefore Google’s revenues which on Android remain half of that generated on iOS.
  • I continue to think that Alphabet remains fair value and I would continue to steer clear of the handset makers whose differentiation looks like it may take yet another hit.


Apple FQ2 17– New normal

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These days, Apple looks like an industrial. 

  • Apple reported reasonable results and in increasing both the dividend and the share buy-back program, ushered itself squarely into a new normal of pedestrian growth.
  • FQ2 17A revenues / EPS were $52.9bn / $2.10 broadly in line with consensus at $52.9bn / $2.02.
  • Gross margins were 38.9% at the high end of the guided range and slightly above consensus at 38.7% as the iPhone 7+ was a stronger contributor to the mix than anticipated, lifting profitability.
  • Unit shipments were:
    • 50.8m iPhones vs 51.4m expected with an ASP of $655 compared to $666 expected.
    • Note that a higher than expected inventory adjustment (1.2m units) more than accounts for the difference.
    • 8.9m iPads and 4.2m Macs also shipped with Macs faring a little better than expected.
  • Services continued to be very strong with $7bn in revenue growing by 18% YoY with Apple stating that it now has a total of 165m paid subscriptions.
  • This includes Apple Music, iCloud and the subscription services of others that it offers on the Apple App Store.
  • There is obviously a degree of double counting going on here where for example, Spotify subscribers who pay through the App Store are also included here.
  • In my opinion, this renders this number virtually meaningless as Apple is counting subscriptions of its competitors as its own although it will still be making some money from these subscribers.
  • This combined with both an increase in dividend and the share buyback program, indicate very clearly that there is no growth in this company unless it can conquer a new segment.
  • Having (rightly, in my opinion) given up on making a car (see here), there is no new segment in sight, and so I see Apple, by and large, growing in line with the world economy.
  • I suspect that it will swing above and below that average as new products drive replacement cycles but the long-term outlook is industrial in its nature.
  • The next swing is likely to come from the iPhone 8 for which speculation and anticipation is already at fever pitch.
  • This means that Apple has to come up with something pretty special to see another cycle that will push its revenue growth above its new long term average, albeit temporarily.
  • Fortunately, the valuation of the company is not too demanding with a PER of 13.0x but the buy case based on valuation has now evaporated.
  • I see very little upside other than income coming from the shareholder return programs.
  • I would prefer Microsoft, Baidu and Tencent for those looking for capital appreciation.


Apple vs. Qualcomm – Proxy war

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Apple’s intransigence plays into Qualcomm’s hands. 

  • Qualcomm has been forced to adjust its guidance for the coming quarter after being informed by Apple that it would not be receiving any royalties for the foreseeable future.
  • According to Qualcomm (as Apple has made no statement), Apple has ceased payment as it finds the contract terms unacceptable even though it does acknowledge that some payment is warranted.
  • Qualcomm’s new FQ3 16 guidance is for revenues / EPS that will be $500m – $800m (midpoint $650m) and $0.15 – $0.30 lower than the guidance given at the recent FQ2 16 results.
  • Although the issues that Apple has with Qualcomm’s business model are very similar, if not the same as the issues that Nokia had back in 2006, the circumstances are completely different.
  • These are:
    • First Contract validity: The dispute that arose between Nokia and Qualcomm in 2006 occurred because Nokia’s contract had come to an end and the companies were unable to reach agreement on terms for the renewal.
    • Nokia stopped paying Qualcomm as it had no idea how much to pay and instead accrued an estimate of the cost in its balance sheet.
    • The contracts upon which Apple has ceased payments have not expired and I can’t see any real contractual grounds upon which to cease making payments.
    • As a result, I do not think that it will not be difficult to show to a court that Apple is acting in bad faith and to win an enforcement order.
    • Second: Third party suppliers. Apple does not pay Qualcomm directly as the payment is made by its manufacturing partners who make its products.
    • This means that Apple is getting involved in contracts that are in place between entities that have nothing to do with Apple other than it is the end buyer.
    • I do not think it will be difficult to argue that Apple has no real grounds to be involved in these contracts and is acting in bad faith.
  • Apple’s intentions are clear in that wants a lower rate from Qualcomm and unlike Nokia, is not prepared to wait until current contracts expire before launching its proxy war via its suppliers.
  • Apple’s royalties are calculated on the wholesale price of the device which in this case will be the price at which the supplier sells the finished device to Apple.
  • I calculate that the supplier is paying Qualcomm 2.8% of the price of the device from making the below assumptions:
    • Qualcomm’s FQ3 17 royalty revenues from Apple would have been from calendar Q1 17 as royalties tend to paid one quarter in arrears.
    • Apple shipped 52m units in calendar Q1 with an ASP of $650 giving iPhone revenues of $33.8bn upon which it made gross margins of 45%.
    • This means that suppliers sold the devices to Apple with an ASP of $448 for a total revenue of $23.3bn
  • There are a number of caveats to this assumption:
    • First price cap: There is a price cap above which no royalties are paid.
    • This cap was originally meant for products like laptops with modems, but premium smartphones are now so expensive that they often hit this cap.
    • I have estimated that this cap is somewhere around $500 but if it is as low as $400, then the rate I calculate paid by Apple goes up to 3.1%.
    • Second pay up front: There is a pay-up-front option (which Nokia took advantage of) which allows the vendor to pay a lower rate going forward.
    • It is not clear whether contracts with the iPhone suppliers have made use of this option or not.
  • The net result is that I calculate that Apple is paying somewhere around 3% to Qualcomm which I think is at least on par with many other vendors.
  • The problem with patents as there is no real way to determine what should be paid to for them.
  • I have long believed that patents are worth either:
    • First: what an entity is prepared to pay for them or
    • Second: the present value of the cash flows that the patent generates.
  • This is why historical precedent is so important when it comes to patent licencing and here Qualcomm has a huge advantage.
  • Qualcomm has hundreds of agreements and more than 20 years of history as evidence that its agreements have not damaged the mobile industry, in fact, quite the reverse.
  • Furthermore, I think Apple’s intransigence on this issue and ceasing payments that it has already agreed to in writing, plays enormously to Qualcomm’s advantage.
  • Courts look poorly upon a refusal negotiate and acting in bad faith and I think that Apple has done more harm than good to its case here.
  • Hence, I think Qualcomm’s chances of prevailing against Apple are better than they were against Nokia which is all the more reason why it should fight tooth and nail to preserve its business model.

Samsung Q1 17 – Roaring 40s

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Semis is a powerhouse with growth and margins in the 40s.  

  • Samsung reported a superb set of results driven largely by semiconductors but announced that it would not be re-organising into a holding company much to the dismay of some activists.
  • Q1 17 revenues / EBIT were KRW50.6tn / KRW9.9tn compared to consensus forecasts at KRW49.5tn / KRW9.18tn.
  • At the same time Samsung announced its first ever dividend of KRW28,000 (annualised) giving a yield of around 1.4%.
  • It also announced that it would keep its promise to cancel all of the treasury shares that it has bought resulting in a further return to shareholders of KRW40tn.
  • This is a promise that many US and European companies implicitly make when they ask s for permission to buy back shares but in practice, rarely keep.
  • For me, this is far more important to shareholder value than re-organising into a holding company.
  • I view holding companies as conglomerates where good intentions are, more often than not, ground down into inefficiency, bureaucracy and slowness.
  • Consequently, I do not see Samsung’s reticence to become a holding company as a bad thing for shareholders.
  • Semiconductors was the powerhouse of these results posting 40% YoY growth with EBIT margins of 40% making up 63% of total profits.
  • The handset business was much less exciting with a 17% YoY decline in revenues and EBIT margins of 9.2%.
  • Even if I reverse out the KRW1.0bn hit that was taken during Q1 17 in the handset business for the Note 7 disaster, I still have only 14% EBIT margins.
  • While Samsung’s margins in Android are exemplary compared to its Android competitors, its semiconductor margins are industry leading, handsomely beating even Intel at the operating level.
  • Consequently, I think that it is this business that will be the main driver of performance for the balance of 2017.
  • In that regard, the outlook remains good with steady demand coming from servers and handsets and no imminent threat to its domination of the memory industry.
  • The implosion of Toshiba and potential change in ownership can only continue to benefit Samsung Semi in 2017.
  • This could be further enhanced should Apple decide to move to OLED in its next iPhone generation for which Samsung is the most likely supplier.
  • This should help provide some stability to the display business which is notorious for its wild swings between profit and loss.
  • The net result is that the outlook for Samsung this year remains very healthy with only one uncertainty on the horizon.
  • This is the unquantified damage that has been done to the brand following the Note 7 disaster raising questions with regard to shipments of the Galaxy s8.
  • Despite this, the initial signs are good as the reviews of the device are overwhelmingly positive despite the software shortcomings (see here) and pre-orders are pointing to no lasting damage having been done.
  • Admittedly, I put the brakes on this one too early by deciding to call time in Q4 16 when the scale of the Note 7 disaster became apparent.
  • Now with the share price above KRW2m, the opportunity for further upside is less obvious leaving me to continue preferring Microsoft, Tencent and Baidu.