Google Q1 – Price of success

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Mobile pricing is likely to stay low for a while.

  • Google failed to beat expectations as pricing fell by more than expected due to the shift of spend from desktop to mobile.
  • Q1 14 Revenues and adjusted EPS were $12.2bn / $6.00 compared to consensus at $12.3bn / $6.39.
  • Profitability fell short as gross margin fell as a result of lower pricing while the cost of traffic acquisition continued to grow.
  • The company pointed to some one off costs in R&D as result of recent acquisitions but this did not alleviate the concerns around pricing.
  • The main problem is that, at the moment, an advertisement or search attracts a significantly lower price on a mobile device than it does on the desktop.
  • There are two main reasons for this:
    • First: The small screen is less effective for marketing as there is less spare real-estate and acting on a marketing message is more complex and potentially expensive for the user.  
    • Second: Mobile payments remain in the stone age which means that impulse purchases in response to a piece of marketing happen infrequently.
  • Hence, the return on investment for an advertiser when looking at sales from a mobile device from advertisements on mobile are lower than they are for the desktop meaning that they attract a lower pricing.
  • Google is trying to change this in two ways.
    • First: By educating the marketers to the value of cross-screen marketing. i.e. an advertisement seen and acted on in mobile resulting in a transaction by the same user on another device.
    • Second: Improve mobile payments such that it becomes quick, simple and secure to transact direct from a mobile device.
  • If Google can help fix these issues on the devices that it controls then there should be a convergence of advertising pricing between fixed and mobile.
  • Given what will now be baked into expectations this would be positive for Google but it is going to take some time.
  • The technology industry has been struggling for more than 10 years to get mobile payments to work and it is still struggling.
  • Hence I do not expect this issue to be fixed anytime soon.
  • However, if advertisers can be made to understand the value of cross platform, then some progress on pricing could be made in the short term.
  • Hence long-term I think that mobile pricing will improve but this looks like an issue that will crimp growth this year.
  • That being said, Google is in the best position of any ecosystem player to see growth from the mobile ecosystem.
  • Hence it remains one my favoured plays alongside the more controversial contenders Yahoo! and Microsoft. 

Yahoo! Q1 – Lucky tailwind

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Opportunity remains but time shortens.

  • Yahoo! reported reasonable results from its core operations while it was Alibaba that drove Net Income to be above expectations.
  • Revenue / Net Income were $1.09bn / $402m beating consensus of $1.08bn / $372m by 1% and 8% respectively.
  • This was almost entirely driven by Alibaba which grew revenues by 66% and Net Income by 110% soundly beating most people’s expectations.
  • However, there are signs of improvement as display revenue saw its first YoY growth since 2011 with growth reaching 2%.
  • This is a major milestone confirming the trend of the last 5 quarters and following the growth of traffic across Yahoo! properties.
  • I suspect that display growth will not accelerate much beyond 3% or 4% as display is not as good as search and more importantly Yahoo! position in mobile remains weak.
  • However, as long as display can remain in positive territory, this gives the company a platform from which to grow revenue in other areas.
  • Here the company was again at pains to point out that it is all about mobile as that is where all the growth in advertising spend is currently to be found.
  • This remains Yahoo!’s weak spot as it has the assets but has yet to do a decent job of putting them together to form a decent ecosystem.
  • It is by putting the assets together and really understanding who one’s users are that real value can be created.
  • Yahoo! is very far from this goal but importantly the market gives it no credit whatsoever when it comes to delivering on this proposition.
  • The focus remains on the performance and mooted valuation of Alibaba when it goes for its IPO this year.
  • Once the value of Alibaba has been crystalised, attention will return to the core business where Yahoo! has real opportunity but has yet to deliver.
  • Of delivery there was little sign as guidance was in line with expectations with Q2 revenues expected at $1.08bn compared to consensus at $1.09bn.
  • Marissa still has time to deliver and there are glimmerings of a turnaround but much still needs to be done and the grace period is getting shorter by the day.
  • Yahoo! is still my top ecosystem pick as Alibaba gives some downside protection while there is substantial upside from a turnaround and development of a mobile ecosystem.
  • If the grace period ends with no delivery then the shortcomings in execution will be obvious for all to see. 

Microsoft – Under the rug

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Microsoft continues to hide its light under a bushel.

  • The reviews of Windows Phone 8.1 are starting to come in and they are pretty positive all round.
  • Those that have lived with the new software for several days are finding that the updates have created a significant improvement in the user experience.
  • New features such as Cortana, Action Center, WiFi/Data Sense and the UI changes have all been pretty well received.
  • Windows Phone still lacks a lot of apps. but this problem is being addressed albeit much more slowly than I had hoped.
  • Furthermore it looks like there is a whole host of Windows Phones being developed for launch this year.
  • Hence the summer and autumn should see something like 8 new devices launched all with the updated user experience.
  • This is exactly the kind of activity that is needed to make the Windows ecosystem a success but a critical piece is still missing.
  • User awareness of Windows Phone and the ecosystem remains almost non-existent and until Microsoft educates the users, many of these improvements will go unnoticed.
  • The majority of Windows Phone devices at retail which potential buyers get to play with have no data on them.
  • This effectively means that they get no real idea of what it will be like to live their Digital Lives with Windows Phone
  • iPhone and Android are brands in their own right but Windows Phone does not have this luxury and so it must tell everyone explicitly why it is great.
  • Microsoft’s marketing to date has been focused on announcing the presence of Windows 8 but has yet to explain to anyone why they should buy it.
  • Until this changes, market share is going to remain far below its potential and the good work of its device and software engineers will go unnoticed.
  • It is encouraging to see improvements at the product end but now the message must be spread far and wide.
  • I am still hopeful that Microsoft can make a real go of its ecosystem as investments in products should logically be matched with investments in marketing.
  • Microsoft has vast resources and I am hopeful that Microsoft is aware of the shortcomings in its message.
  • Microsoft along with Yahoo! and Google are my favoured ways to look at the mobile ecosystem. 

Google – Turn of the screw

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  • Google is the only winner in the Android ecosystem.
  • June is becoming one of the most important months of the year for the mobile ecosystem with both Apple and Google holding developer events.
  • Hardware is pretty much commoditised meaning that the features which are increasingly going to make the difference for users are being revealed at these sorts of events.
  • Microsoft’s BUILD conference (see here) last month was exactly the same.
  • Apple is likely to launch iOS 8 with a range of new features (see here) while it looks like Google will be taking more and more control of Android.
  • Hence I suspect that Google I/O will showcase substantial improvements being made to Google applications and services.
  • Tw in particular that I am looking for are a substantial improvement in the Google Calendar application and functionality enhancements to the Google Camera App.
  • While these improvements are good for users, it is turning the screw even tighter on the long suffering handset makers.
  • Google is slowly but surely taking control of Android by moving functionality out of the open source Android Open Source Platform (AOSP) and into Google Mobile Services (GMS).
  • AOSP is open source but GMS is not, meaning that handset makers must comply with Google’s standards or be cut-off from all of its applications.
  • In emerging markets this is less important but in the West, Google Play is critical to the user experience meaning that neither operators nor handset makers can afford to be cut off.
  • This effectively means that Google is taking over the user experience in Android and any hope that the operators vendors may have had in differentiating their offerings has now evaporated.
  • This will ensure that brutal competition continues in Android devices meaning cheaper devices with better hardware specification in the hands of users.
  • Better devices with Google services will mean higher usage and more traffic for Google to monetise.
  • It also means commodity margins (if any) for the Android vendors and a bit pipe future for the operators.
  • Samsung is the only Android vendor making any money at the moment but its recent decision to back off from developing its own services looks set to push its margins towards those of its peers.
  • There is only one company in the Android ecosystem worth taking a serious look at the moment and that is Google.
  • Yahoo! and Microsoft are the other two ecosystem players which I think have potential that everyone is currently ignoring.

Apple vs. Qualcomm – Black magic

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Apple is likely to stay away from the black art of cellular radio.

  • News articles and recent hires by Apple suggest that Apple may be moving into developing its own basebands.
  • This could have significant negative implications for Qualcomm for whom Apple makes up a substantial portion of sales.
  • This would imply that Apple wishes to integrate its in house applications processor with a baseband in order to produce a smaller more power and cost efficient component.
  • Given Apple’s desire to vertically integrate its products, this move would make some sense but I think it extremely unlikely for the following reasons:
  • First: A lot of the value in silicon has moved from the baseband into the applications processor. Hence the cost saving of moving to internally source a baseband would not be that great.
  • Baseband-only chips are way down the rate cards of Qualcomm, MediaTek and Broadcom.
  • Furthermore, much of the integration with hardware and software in smartphones occurs in the application processor where Apple’s solution is already well developed.
  • Second: RF is really difficult.
  • Cellular radio is a black art where experience often counts for more than pure engineering expertise.
  • This will make organic growth of an in house baseband a very long, expensive and laborious process.
  • Furthermore, it is unlikely to ever really catch up with Qualcomm and MediaTek in terms of product quality and cost.
  • Third: If Apple wanted to get into basebands why did it not outbid Broadcom for the Renesas baseband business?
  • This team originated from Nokia and consequently has a wealth of RF expertise and most importantly an excellent LTE solution.
  • This team is now the last hope of Broadcom’s baseband business but it could easily have been the core of an in house baseband at Apple.
  • This is an area where I suspect it will be cheaper and better to buy in.
  • Fourth: The pedigrees of the two hires that we know about, suggests expertise in the components that sit around the baseband (such as transceivers) rather than the baseband itself.
  • There are some difficult problems coming as LTE becomes more mainstream that relate to radio bands and filtering which will be important for Apple to have some expertise in as things get more complex.
  • Hence, I think these hires are about Apple moving to understand the radio complexities of its own products rather than the cellular protocols themselves.

Take Home Message

  • At a high level, Apple’s history suggests greater vertical integration but inclusion of the baseband in that strategy makes no sense.
  • In all probability, an in house baseband would probably end up costing Apple more and resulting in significantly worse performance.
  • Hence, I suspect that Apple will concentrate on that which it knows best and leave the dark art of radio to those that have been doing it for 20 years.
  • Any resulting weakness in Qualcomm represents an opportunity. 

 

Blackberry – No prisoners

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Life without handsets will be little better than with.

  • John Chen has finally admitted the possibility of failing to turn around Blackberry saying that the company will exit handsets if it can’t turn a profit.
  • This would result in Blackberry becoming just another Mobile Device Management (MDM) vendor like AirWatch, Mobile Iron and Good.
  • This space is crowded and increasingly, it is the big IT vendors that are moving in to take over.
  • VMware’s $1.54bn takeover of AirWatch is unlikely to be the last in this space.
  • This will create a horrible problem for BlackBerry.
  • Firstly, it is already behind the others as it has to retrofit its service to offer cross platform support whereas the others have been designed from the ground up with this in mind.
  • Secondly, most of these large vendors sell other products into the enterprise and can afford to give this service away in order to cement business in other areas.
  • This will make life extremely difficult for Blackberry and I doubt whether it will survive on its own as a pure MDM vendor.
  • Even if Blackberry does make it work in MDM, the valuation of the company is likely to be far less than it is today.
  • This is because of the nature of hardware and software.
  • A hardware business typically has high revenues but lower margins as the ASP per smartphone will be around $200.
  • A software business based on smartphones will attract a fraction of that per device resulting in much lower revenues but higher margins.
  • Even in this instance, revenues will be far lower without hardware meaning that it will be increasingly difficult to justify a valuation of $4.2bn on software revenues alone.
  • I think that it is extremely likely that this is the road that John Chen will be forced to take.
  • He thinks that he can make money shipping 10m units a year.
  • This looks like a tall order given that Android vendors Huawei and LG Electronics are struggling to keep their heads above water shipping 50m smartphone units last year.
  • I have a lot of confidence in John Chen, but unlike Sybase, there is too much out of his control at Blackberry and that means that the handset business is likely to fail no matter what he does.
  • The handset market takes no prisoners when it comes to profitability and Blackberry is one of the weakest, most vulnerable players out there.
  • What is more, everyone knows it and is coming after its customers with a vengeance.
  • Hence, I suspect that he will announce a move to become a pure MDM player towards the end of this year which will mean a huge leg down in valuation as the recovery potential will be that much lower in absolute terms.
  • Investors should get out now while some are stilling willing to believe that the handset business can be turned around. 

 

 

Apple iOS 8 – No silver bullet

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iOS 8 is not going to solve the long term services problem.

  • Apple’s hardware and its ecosystem are world leading but both of them are being slowly replicated by competitors.
  • Only apps and services that are exclusive to Apple will allow it to really differentiate in the long term and of these there is little sign.
  • What there is today does not cover Digital Life very well and many of the services such as Apple maps and iCloud are not as good as alternative offerings.
  • Hence, there is some hope that iOS8 will go some way towards addressing this issue but the rumour mill is not particularly encouraging in that regard.
  • First, Healthbook.
  • This is a service that tracks and aggregates health related data such as blood pressure, heart rate, blood pressure and health history in one place.
  • It is in effect a medical record that the user carries around and updates as things change.
  • The problem with this is that the user will have to input and maintain all the data manually making it cumbersome and labour intensive to use.
  • Unless this can be automated and made cool and fun in some way, I can’t see this being of much interest.
  • Second: Apple maps.
  • A big update to this service is expected and it is hoped that this will bring it into line with Google Maps and Here.
  • I think that this is extremely unlikely.
  • Maps are not rocket science. They are labours of love.
  • On average it takes 6 years, 6,000 people and $600m in annual OPEX to create a good map and I am convinced that Apple is investing a fraction of the required amount.
  • Hence, I suspect that Apple is still miles adrift of Here and Google and I remain unconcerned their edge is about to be eroded.
  • Third: iTunes Radio.
  • iTunes radio is expected to be moved into its own application to boost its recognition and support.
  • This will do little to improve its user experience when compared to Pandora, Deezer, Spotify and so on and so I expect that users will continue to use the services to which they like and to which they have become accustomed.
  • All of these services have one huge advantage in that they will be embedded in every device that ships and will be set as the default services.
  • History has shown that this is a huge advantage and usage of Apple maps has improved meaningfully as a result of this factor.
  • This will go some way in addressing the functionality and coverage shortfall but it will allow Apple to maintain premium pricing for hardware.

 Take home message

  • While iOS8 looks like it will be a solid update, it will not fix the longer term problem that Apple faces.
  • Apple needs to come up with innovative and fun ways for people to live their Digital Lives on Apple devices that cannot be replicated elsewhere.
  • Failure to do this means that margins are likely to steadily erode to around the 10% level over a number of years. (RFM estimate).
  • In the short-term the outlook is stable and I am hopeful that the iPhone 6 will bring Apple back into contention with Samsung, HTC, LG and others in terms of hardware specification.
  • The Apple story is well known and fairly priced. There are much more interesting places to look such as Yahoo!, Google and Microsoft. 

Samsung and HTC – Chalk and cheese

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Samsung is about growth. HTC is about survival

  • Both Samsung and HTC have reported preliminary results and neither are very encouraging.

Samsung

  • Samsung preliminary Q1 14A revenues / EBIT will be KRW51tn-KRW55tn / KRW8.2tn-KRW8.6tn giving mid points of KRW53tn / KRW8.4tn respectively.
  • These midpoints are broadly in line with consensus revenues / EBIT of KRW54tn / KRW8.3tn.
  • The IT and Mobile Coms. (handset) business has performed in line with expectations with EBIT of around KRW5.9tn (RFM and consensus).
  • This implies a strong increase in profitability in handsets after the extra marketing and one off bonuses in Q4 have not re-occurred.
  • Despite being in line with estimates, IT and Mobile Coms. EBIT has declined by 6.6% compared to Q1 13 which really underlines the issue that Samsung faces.
  • The smartphone market is slowing and the company faces pressure on its profitability as competition gets ever more intense.
  • Hence, in order to see growth, the other businesses need to really step up which will be difficult given that Semiconductors are already very profitable and much of the rest of the business is already a commodity.
  • Hence, without a stellar success from the Galaxy s5 and Galaxy Note 4 (due later this year), earnings are going to fall this year.
  • The company believes that the second half of the year will see a recovery but without meaningful growth in handset market share this looks like a tough nut to crack.
  • Hence I am forecasting an 8% fall in EBIT for the full year compared to consensus which is forecasting 3% growth.
  • There seems very little upside to be had in the shares this year despite the company’s cheap valuation.

HTC

  • HTC reported weak preliminary Q1 14A results but the revenue miss can be attributed to a delay booking revenues due to IFRS.
  • Revenues / Net Income were TWD33.1bn / LOSS 1.9bn compared to consensus at TWD35.4bn / LOSS 1.7bn.
  • The only good news in these numbers is that March did see revenues increase and none of these figures include any shipments from the company’s new flagship the HTC One M8.
  • This is an excellent device but HTC does not have the marketing power to push this device very hard and it is coming at a very high price.
  • It would not be the first time a superior product was buried under the weight of a bigger marketing budget for an inferior one.
  • There are mixed reports of how well the device is selling but the key will be how fast sales drop off once the initial euphoria fades away.
  • Either way it will take a miracle for this product to save HTC as there are many almost-as-good products from stronger brands which have bigger marketing budgets.
  • Hence, I do not see the HTC One M8 pulling HTC from its current death spiral and, together with Blackberry, I see HTC as one of the first casualties of the coming shakeout.
  • Investors should exit from both of these companies while there are those still willing to believe in a recovery. 

Microsoft – Increment not detriment

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Two steps forward. None back.

  • Microsoft made two good steps towards improving the appeal of the Windows ecosystem to both users and developers at its BUILD conference.
  • First. Windows will now be free for all devices which have a screen size of 9 inches or less.
    • With Nokia’s smartphones business soon to be part of Microsoft, this move has no meaningful impact for revenues.
    • Other handset makers make tiny volumes of Windows Phone devices and this move is unlikely to change very much from their point of view.
    • This is because the biggest problem will now be Microsoft’s lack of independence with an in-house customer.
    • This is exactly the same problem that many handset makers had with Google owning Motorola and I think that it is no co-incidence that Motorola was sold to Lenovo within days of Samsung and Google becoming best friends again.
    • Hence, this move is very unlikely to change the status quo where Microsoft will remain by far the dominant shipper of Windows Phones.
    • It is elsewhere in the Internet of Things where this might become more interesting.
    • These devices are showing every sign of being very specific to the use case for which they have been designed.
    • For example a thermostat and a connected kitchen scale have very specific functions and hardware meaning that there is little requirement for third party apps.
    • However, they will be required to feed data into a wider ecosystem on a phone, tablet, PC, TV or console and here this software could be attractive.
    • If the OS on the device already knows how to talk and interact with the devices that make up the real ecosystem then it has an advantage over stand-alone offerings where the software has been developed in isolation.
    • By making the embedded software available for free, Microsoft makes its proposition one worthy of serious consideration by anyone creating a connected device.
    • Microsoft benefits by adding depth and richness to its ecosystem which I suspect that it will find other ways to monetise.
    • This combined with the new development environment (see below) could meaningfully enhance the appeal of Microsoft to those creating cutting edge devices and services.
    • This is something that the Windows ecosystem sorely lacks and it would be a big step up if the entrepreneurs can be brought into the fold.
  • Second:  A new developer environment was launched which allows developers to write a single app that will run on Windows Phone, Windows 8.1 and Xbox One.
    • This is a big step forward as it shows that Microsoft is at last beginning to bring together the assets that have long been lying around in different parts of the company.
    • Having an ecosystem that seamlessly can jump from one device to another is something that Microsoft is in the best position to deliver.
    • Apple’s Digital Life services are not yet strong enough to make this a reality and its software does not work well with devices made by others.
    • Google is well positioned to deliver this but the endemic fragmentation in Android makes the functionality almost impossible to deliver at the moment.
    • Furthermore, Microsoft’s latest demonstrations of its ecosystem are beginning to show real understanding of user behaviours across multiple devices.
    • If this can be clearly demonstrated to users and the popular fixes (Start button) to Windows are delivered, then Windows 9 could be everything that Windows 8 was not.
    • This developer tool will enhance the appeal of the ecosystem to developers and encourage them to go beyond Windows 8.1 with very little effort.
    • Again this is something that Microsoft can deliver better than its ecosystem competitors.

 

Take Home Message

  • For me, the most positive development from the BUILD conference is that Microsoft seems to be leaning towards becoming an ecosystem company rather than hunkering down and focusing just on the enterprise.
  • The fact that a version of Windows is now openly available for free is a clear sign that there is fresh air circulating in the halls of Redmond.
  • The strategy to become a full ecosystem company for both consumers and the enterprise is the hard choice but it is the right choice.
  • Value creation for shareholders will be much greater in the longer run but there do remain risks when it comes to execution.
  • 50 days in and it looks like the right choices are being made.
  • Microsoft and Yahoo! along with Google remain my favourite places to be this year. 

 

 

BlackBerry Q4 – Last lap?

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Q4 gives no reason to hope.

  • BlackBerry reported disappointing results as the two most important metrics of a company in trouble (revenue and cash flow) were very weak.
  • Q4 revenues / EPS were $977m / LOSS $0.06 compared to expectations of $1.11bn / LOSS $0.57.
  • $553m of cash was consumed during the quarter giving the company just over a year should cash consumption continue at this rate.
  • The good news is that John Chen is living up to his reputation and is tightly controlling the metrics that he can.
  • OPEX is already meaningfully down and inventory has been reduced by one third.
  • However, at the same time the things that he can’t control are likely to mean that BlackBerry has no real future.
  • BlackBerry devices and services are horribly out of date and have very little appeal to users.
  • The new releases are unlikely to change that appeal much as the focus appears to be backward-looking rather than forward.
  • Devices such as the Classic may help margins as it is being designed on the basis of the components that the company has lying around in inventory.
  • However, this will provide only a temporary respite as when the inventory is cleaned up, BlackBerry will be once again exposed to full market pricing for components.
  • Rivals such as Microsoft, AirWatch, Good and MobileIron have decent device management solutions that cover all platforms.
  • These companies are making strides with their security credentials and even BlackBerry’s most august customer, The White House, is trialling other solutions.
  • BB12 offers full backward compatibility which is excellent, but the subscriber base is already below 60m and falling fast.
  • It will be another 8 months before this is ready for roll-out by which time another 20m subscribers will be have deserted the platform.
  • The problem remains unchanged in the there is no room left for BlackBerry.
  • It has chosen to vacate the consumer market and in the enterprise its rivals have caught up and are now on a much sounder financial footing.
  • The only asset it has left is the installed base and this is evaporating fast.
  • I continue to believe the only real future for BlackBerry is a break-up and this values the shares at around $4.
  • Those still hanging on should head for the exit now.