Yahoo! – Nowhere to go

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Yahoo! had little choice but to stay with Microsoft.

  • The changes that have been made to the search contract between Microsoft and Yahoo! are cosmetic and reveal how Marissa Mayer is still failing to breathe any real life into Yahoo!.
  • Microsoft and Yahoo! have extended their search agreement made in 2009 where Microsoft will power Yahoo!’s desktop search and pay Yahoo! a percentage of the advertising revenue as TAC (Traffic Acquisition Cost).
  • There are two changes:
    • First. The relationship is no longer exclusive meaning that Yahoo! can use other search providers (including its own).
    • Second. Sales teams have split responsibility along the fault lines with Microsoft dealing with all ads delivered by Bing and Yahoo! for its own Gemini advertising platform.
  • While this reads like an improvement in the terms for Yahoo!, in practice very little is likely to change.
  • Search is now effectively a one horse race with one challenger struggling along in distant second place.
  • Yahoo! effectively has nowhere else to go and whatever in house development it has attempted is clearly not good enough to replace Bing.
  • It was only a few quarters ago when it was widely thought that Marissa wanted to exit entirely from the deal with Microsoft and go it alone.
  • Clearly at the time she felt strong enough to do that but much has changed in the last 18 months.
  • Yahoo!’s revenues have continued to flounder despite $1.2bn of revenues in 2014A coming from mobile.
  • Furthermore, analysis of these figures in combination with Yahoo!’s assets shows that it underperformed its revenue potential in mobile by $4.4bn in 2014A (see here).
  • This combined with a lack of execution on integrating and improving its ecosystem and moving it into mobile, leaves Yahoo! in a weak position when it comes to negotiation.
  • This is why I suspect Yahoo! has agreed to renew this contract despite a clear desire to go it alone and it does not bode well for the future.
  • Yahoo! will report Q1 15E earnings on 21st April 2015 and I do not expect it to be a happy event.
  • I think that revenues have continued to drift sideways highlighting the underperformance of Yahoo! against its peers like Google, Facebook, and Twitter among others.
  • Yahoo!’s problems can be summed up in one word: execution.
  • The acquisition strategy has been excellent as Yahoo! has gathered a good offering of Digital Life services from which it can build a thriving ecosystem.
  • Furthermore it has a strong user base and high usage in the fixed internet upon which to build.
  • Unfortunately, acquisition is where the story has stopped as nothing seems to have been done with regard to putting them all together into a coherent, easy to use and fun way on mobile.
  • This is the single biggest challenge facing Yahoo! and until it begins to execute on this, its numbers will continue to drift sideways or downwards.
  • Yahoo! will dress up the story in many ways but the numbers speak for themselves.
  • Microsoft is a challenger that is far more likely to succeed and Google is the only way to be exposed to the Android ecosystem.

 

Netflix Q1 15A – The balance of power

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Everything depends on Netflix achieving scale.

  • Netflix reported Q1 15A results slightly below expectations but the subscriber growth was better than forecast and this continues to be the main driver of the shares.
  • Q1 15A revenues / EBIT were $1.57bn / $97.5m compared to consensus at $1.57 / $106m but all the attention was on the subscriber count.
  • Netflix added 2.28m subscribers in the US and 2.60m elsewhere to bring the total to 62.27m of which 59.62m (96%) are paying subscribers.
  • Total net additions of 4.88m subscribers in Q1 15A was ahead of company guidance of 4.1m which has been attributed to NetFlix’s increasing stable of exclusive shows headlined by House of Cards.
  • The company is starting to see some benefits of scale as gross margins in the US improved to 31.7% ahead of company guidance at 30.1%.
  • International, with its much smaller user base continued to see negative gross margins.
  • Guidance was pretty cautious with 2.5m net additions expected and revenues / EBIT of $1.47bn / $59 compared to consensus of $1.66bn / $132m.
  • This did nothing to halt the unbridled optimism based on the user numbers that sent the shares up 12% in after-hours trading.
  • As Netflix grows its user base and relies more heavily on its own, exclusive content, three main dynamics driving the business model emerge.
    • First. Netflix is becoming similar to a software company.
    • Netflix incurs low additional costs to deliver its exclusive content to additional users.
    • This means that if the company can continue to increase its user base then substantial improvements in gross margins are probable.
    • They are never going to reach the 90% that Microsoft can earn as the cost of delivering the content is a meaningful factor, but they should be able to reach levels far above where they are today.
    • Second. Netflix is becoming a data company.
    • A significant percentage of the domestic market are using its service and critically it knows far more about its users than the cable or satellite companies do.
    • This data gives Netflix the ability to suggest and curate content that it knows that its users will like based on their viewing habits.
    • This will mean it knows exactly to whom to market its new and existing shows making marketing much easier and much more efficient.
    • Netflix currently spends 12.3% of revenues on marketing which I think could be meaningfully brought down over time.
    • This data could also be used for advertising and a free tier of service but given almost everyone pays for the service today, this is unlikely to happen any time soon.
    • Third. If subscribers continue to grow, then the balance of power will begin to shift in its favour.
    • Content creators will increasingly realise that they have to have their content on Netflix to reach the mass market giving Netflix much more power when it comes to content rights negotiations.
  • All of these factors should have a positive impact on gross margin and OPEX over the long term but are completely dependent on Netflix’s ability to reach critical mass.
  • RFM’s ecosystem research strongly suggests that this critical mass will start to really factor in gross margin when the company passes 100m subscribers.
  • Netflix is now trading on 162x and 108x 2015E and 2016E PER and 4.8x and 3.9x 2015E and 2016E EV/Sales indicating that much of this margin story has already been priced in.
  • The revenue and critical mass element has clearly not been priced in, and this could be a source of upside if it becomes clear that Netflix will pass 100m subscribers.

Intel Q1 15A – Data centric

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Data centres rescue the quarter but not the year.

  • Intel reported Q1 15A results in line with reduced expectations but guided well thanks to the continued strength of the data centre.
  • Q1 15A revenues / EPS were $12.8bn / $0.41 which was exactly in line with consensus given the profit warning given earlier in the quarter.
  • As usual, the problem was the PC market but in this instance it was not the consumer but the small and mid-size businesses that bought fewer PCs than expected.
  • Last year, the ending of support by Microsoft for Windows XP drove many business to upgrade their PCs to Windows 7.
  • This trend drove the PC market to recover slightly in 2014A but the trend has ended more quickly than expected.
  • To keep the momentum going a pick-up in the laptop replacement cycle was needed which is something that I think can only be driven by tablet PCs. (see here).
  • Without this pick-up in the laptop replacement cycle, the result is a weaker than expected market.
  • I expect that this scenario will persist until users begin to understand how much better the use case for a tablet PC is over a laptop and make the switch.
  • Unfortunately, these advantages are not obvious and until Intel and Microsoft get their act together and start explaining the proposition, users are unlikely to bite.
  • The good news is the data centre where demand has been stronger than expected allowing Intel to guide better than feared.
  • Q2 15E revenues will be $12.7bn – $13.7bn ($13.2bn) which is slightly behind consensus of $13.5bn but clearly the market was braced for much worse following the profit warning in Q1 15A.
  • Intel also moved to account for weaker expectations overall for the PC market in 2015E by reducing its full year revenue forecast from mid-single digit revenue growth to approximately flat.
  • This puts an end to any hopes of revenue growth and moves Intel into line with RFM forecasts which is forecasting a decline of 1.3% to 311.8m units in 2015E.
  • Profitability remained strong as the mix shift towards the data centre is helping gross margins remain in the low 60s.
  • That being said, Intel is taking a more cautious stance to 2015E and is trimming capex and share buy backs to reflect its expectation that cash flow will be lower than originally budgeted.
  • Intel’s mobile business is on track to lose $3.2bn this year which is $800m less than last year but represents a huge investment.
  • Intel is effectively paying companies to make devices that use its chips and still none of these have gained any real traction in the market.
  • With every quarter that passes, Intel’s challenge to ARM in the mobile market weakens and throwing good money after bad is not helping.
  • Consequently, I do not see Intel mounting a credible challenge to ARM in the mobile market but at the same time ARM’s forays into PCs and servers have also not been successful.
  • Intel and Microsoft would be my top choices for ways to play a recovery in the PC market but for another year it looks like my hopes will be dashed.
  • In the long term, Microsoft and Google remain the best ways to play the digital ecosystem.

 

 

Nokia – Here and now

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It is too early to sell HERE.

  • It seems that Nokia may be seeking to acquire part of Alcatel-Lucent (I presume the wireless assets) and to pay for it by selling the HERE business.
  • The acquisition of Alcatel-Lucent’s wireless business makes some sense as infrastructure is a brutal market dominated by two players.
  • At one end of the market there is Ericsson which is the technology leader and at the other there is Huawei which is the cost leader.
  • Between them they have created a balance in the market but for anyone caught in the middle, the outlook has always been pretty bleak.
  • That being said, Rajeev Suri has done an excellent job at turning Nokia Networks around and the timing of buying Siemens’ out of its share was perfect.
  • Now it is running smoothly, it is time to turn his mind to the long term and with Ericsson and Huawei both meaningfully bigger than Nokia Networks, the outlook is pretty tough.
  • More than handsets, infrastructure is a game of scale where one needs to maximise the revenues over which to spread the fixed costs of Research and Development and Sales and Marketing.
  • If one lacks scale, then the bigger competitors can still make a decent return while squeezing smaller companies out of the market.
  • This is exactly what is happening in Android and what has been going on for years in semiconductor memory.
  • As a smaller player, Nokia Networks clearly needs more scale and buying the wireless assets of Alcatel-Lucent will help it do that.
  • However, this is a road fraught with risk, as execution of these sorts of mergers in the past has proved very difficult and in every case it has failed to fix the problem.
  • Given Rajeev Suri’s execution of the turn-around of Nokia Networks, He has a good chance of making this work but history is dead against him.
  • The bigger problem for me is that it looks like Nokia is thinking of selling HERE in order to pay for it.
  • HERE is one of only two really credible solutions for a high quality map and following the divestment of the handset business, HERE is the only independent choice.
  • I am pretty sure that Microsoft wanted to acquire HERE as part of the handset deal but was rebuffed in its advances.
  • This is because there is an opportunity for Nokia to really grow market share as Google Maps deals expire and then sell it on for a much higher price.
  • Many of the deals with Google were struck some time ago and many customers now view Google as a competitor and I think would welcome an independent supplier of mapping data.
  • I think that much of this opportunity still lies in front of HERE and as a result selling HERE now for E2bn is doing shareholder a disservice.
  • Consequently, I think that Nokia would be better off holding onto HERE and raising the money via debt.
  • The fact that there are a number of private equity shops all considering bidding for HERE is a good sign of how much value Nokia will be leaving on the table if it sells now.
  • Shareholders will be worse off if it does.

 

 

Twitter – Take no prisoners.

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Another ruthless demonstration of the value of data.

  • The closing of Twitter’s data feed to third parties is a great example of how valuable user data is becoming and how dangerous it is to have large dependencies in a business model.
  • Twitter announced on Friday (April 10th 2015) that it will remove access for third parties to its firehose data feed.
  • This feed is all of the raw data that is generated by the Twitter service that is then analysed by third parties and the results sold onto their clients.
  • In April 2014, Twitter acquired Gnip which is a big data analysis company that sells the results of that analysis onto third parties.
  • At the time of the acquisition, Twitter promised that nothing would change with Gnip continuing to operate independently and being treated the same as the other companies using the Twitter feed.
  • However, the writing has always been on the wall, and now that Twitter is ready to funnel its data to Gnip exclusively, it has moved to cut the other third parties off.
  • This runs the risk that Gnip will now be denied access to the firehose data of other companies, but this is a risk that Twitter had to take.
  • The raw data itself it is not of much value until it has been refined and analysed into something meaningful that advertisers are willing to pay for.
  • Now that Twitter can do this itself, there is little point in giving away revenues and margins to third parties.
  • This is especially the case as Twitter is in danger of running out of growth and needs other avenues from which to derive revenues.
  • I suspect that all of the other major ecosystems who collect vast quantities of data will all end up doing the same.
  • This strongly reinforces RFM research which has long believed that collecting one’s own data from one’s own Digital Life services is a key element to being a successful ecosystem.
  • It also further reinforces the view that dependencies are always dangerous.
  • No matter what assurances one is given, things can quickly change meaning that the dependent can have its business severely damaged in a heartbeat.
  • This is exactly what happens to websites that are dependent for their traffic from Google.
  • When Google changes its algorithms, it invariably has unforeseen effects and can cause an 80-90% collapse in the traffic arriving at a website without warning.
  • At the end of the day Twitter’s first loyalty must be to its shareholders and that means that if it has to cut third parties out for the good of its business then that is what it must do.
  • I expect to see more of these types of moves as the ecosystems become more mature with the easy growth over, forcing everyone dig deeper in the barrel to find the next leg of growth.
  • Microsoft and Google remain my top two choices to look at to gain exposure to the ecosystem.

Apple – The wrong wrist

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Watch expectations are already beginning to fall.

  • The hype surrounding the Apple Watch is beginning to suffer from a healthy dose of reality causing the loftiest estimates to start falling.
  • The range of sales estimates in the first 12 months is huge with the most bearish on less than 10m units and the most bullish on 100m.
  • Consensus is somewhere around 40m which is double RFM’s generous estimate of 20m.
  • The problem is that the reviews of the device are beginning to come in and a clear trend is emerging.
  • The Apple Watch is a nice piece of kit but it is not a must have is the opinion of most reviews and this theme is being echoed by the surveys being done to ascertain consumer purchase expectations.
  • Importantly, the battery life is much better than I expected and can comfortably do a day’s use without having to be recharged.
  • This assumes that fitness tracking is not used because when it is switched on, it substantially increases the power drain on the battery.
  • This battery life is in line with the Microsoft Band which is not as elegant but has the same functions and costs half as much.
  • A BMO survey has found that less than 1 in 10 people who own an iPhone 6 or iPhone 5s intend to buy an Apple Watch.
  • Furthermore, one of the biggest draws for the device is fitness tracking for which there are many other, just as good, but cheaper options.
  • I think the biggest problem is that Apple has targeted the wrong wrist.
  • By designing it as it has and naming it the Apple Watch, Apple has ensured that it must be used as a replacement for the wrist watch.
  • Users will feel very foolish with an Apple Watch on one wrist and a regular timepiece on the other.
  • Other offerings like Fitbit, Microsoft, Misfit and so on are targeting the empty wrist and their products are designed and sold accordingly.
  • As result users don’t feel foolish wearing one of these products as well as a wrist watch whereas Apple has to convince users to consign their beloved timepiece to a drawer.
  • Apple has failed to come up with a killer use case for a wrist mounted computer and as simply come up with a series of gimmicks where the novelty is likely to quickly wear off.
  • Apple will outsell its wearable rivals by a very wide margin but it will do this on the power of its brand and its design alone.
  • This is not enough to sell in anything like the volume that the biggest bulls are predicting and I see further cuts to estimates coming.
  • Consequently, I am sticking to my 20m forecast for the first 12 months and see the potential for some sogginess in the stock as reality sets in.
  • Microsoft and Google remain my preferred ways to gain exposure to the mobile and digital ecosystem space.

Patent licensing – House of cards.

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Standard Essential Patents not at risk of value collapse.

  • The ongoing fight between Google (Motorola) and Microsoft is at risk of setting a legal precedent that could collapse the value of standard essential patents (SEPs).
  • This particular fight was started by Motorola which sued Microsoft for infringement of its MPEG4 (h.264) and WiFi SEPs in PCs.
  • Microsoft counter-sued with a federal suit alleging that Motorola had failed to live up to its FRAND (see below) obligations when it came to licensing its SEPs.
  • Because SEPs are always included within a standard, anyone who makes a product that uses that technology invariably infringes that IPR.
  • To prevent patent holders exploiting the situation, IP that is included in a standard must be licenced on Fair, Reasonable And Non –Discriminatory terms (FRAND).
  • Motorola was seeking a $22.50 from every mid-range laptop that makes use of its patents which with an ASP of $700, is a royalty rate of 3.2%.
  • Microsoft pays a group of 29 companies just $0.02 per laptop to use their pool of 2,300 patents and so it is not difficult to see how Microsoft could make a case for a breach of FRAND.
  • For the first time, the court attempted to determine an appropriate royalty, concluding that Microsoft should pay Motorola $1.8m per year rather than the $4bn Motorola had asked for.
  • Motorola appealed this ruling and it is this appeal that goes before a court in San Francisco today.
  • If the ruling is upheld it will set a very dangerous precedent for all future SEP negotiations as patents are almost impossible to value with royalty payments being almost entirely based on history and precedent.
  • I suspect that the court’s method is deeply flawed in at least one way which is that it is very likely that the court has assumed that all SEPs within a standard are equal in terms of their importance.
  • However, the reality is very different.
  • Patents may look the same but the value of one patent can be hundreds of millions of dollars while an entire pool of similar patents can be virtually worthless.
  • This fact is obvious when look at the patent pools or any association that licences groups of patents for a single fee which is then shares out.
  • These are almost always made up of the weakest patents because the nature of any program dis-incentivises a holder of a strong patent from joining the pool.
  • Qualcomm, Ericsson, Nokia and Motorola have never contributed their wireless SEP patents to a pool because they know their patents are strong and that they can earn higher returns on their own.
  • Historically, the patent holders also manufactured the products meaning that everyone existed under cross licence (much lower royalty) creating a reasonably balanced status quo.
  • However, with the rise of Apple, Samsung and the Chinese this is no longer the case and this is why there is huge pressure from manufacturers to reduce the cost of SEP licensing.
  • Consequently, I think that SEP pricing will continue to fall over time but is unlikely to suffer a big collapse from this court case.
  • This is because I think that the court’s method is fundamentally flawed and suspect that it will not be upheld on appeal meaning that the house of cards that is SEP pricing will stand to fight another day.

 

Samsung Q1 15E – Tight control.

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Samsung appears to have OPEX tightly under control.

  • Samsung has guided to a good set of results as components was strong and OPEX was brought very rapidly under control.
  • Q1 15E revenue and operating profit are expected to come in at KRW47tn and KRW5.9tn compared to consensus at KRW50.1tn / KRW5.5tn and RFM at KRW45.8tn / KRW4.62tn.
  • I see three main factors that are likely to have driven this result.
    • First. Demand for memory appears to have been robust during the last three months and here Samsung is dominant with both market share leadership and superb profitability.
    • Second. I had been expecting a 10% decline QoQ in handset ASPs to clear older stock before the Galaxy s6 as well as continued commoditisation.
    • Samsung typically gains sell-in share in Q1 but it looks like it has not had to cut its prices as hard as I expected to shift its stock.
    • Third OPEX has been tightly controlled in the IT and Mobile Coms business allowing better operating leverage at lower levels of sales.
  • As a result, Samsung has been able to generate more profit than forecast during the last three months.
  • The big question is what the next three months will bring as the Galaxy s6 will be generally available for most of the quarter and a lot is riding on this.
  • Management has led the market to hope that it can return the IT and Mobile Coms unit to mid-teens profitability which I think is unlikely to be achieved.
  • The Galaxy s6 is a nice looking device but outside of hardware driven performance, it offers no functionality that cannot be obtained elsewhere.
  • This is because the user experience is essentially defined by Google which is exactly the same on all handsets which carry the Google apps.
  • Hence, I think Samsung will have to reduce pricing on this device more quickly than expected as it will rapidly become a commodity.
  • With its current market share of 24% in smartphones and its competitors all around 5-8% market share, there are significant scale benefits to be had.
  • These should allow handset margins to return to 10-12% (3x higher than all of its peers) but no further as there is very little differentiation.
  • Consequently, I think that Samsung will miss this forecast and I continue to see a difficult year ahead although the comparisons to 2014A get much easier after Q2 15E.
  • I see little upside in Samsung and scope for disappointment leading me to continue in preferring Microsoft and Google.

 

Microsoft – Beautiful disaster.

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The disaster of Windows 8 can be made an advantage.

  • The degree with which Windows 8 has failed to capture the imagination of users is clear when one looks at the distribution of Windows versions across the PC industry.
  • The latest data from NetMarketShare shows that despite being in the market for 2 ½ years, Windows 8 is still less popular than the operating system that Microsoft discontinued support for last year.
  • To add insult to injury, over the last 12 months Windows 8’s share of Windows PCs has actually declined from 11.3% to 10.6% despite being the newest OS that Microsoft has to offer.
  • I suspect that the main reason for this decline was the spike in corporate upgrades caused by the ending of Windows XP support and a surge in Windows 7 purchasing.
  • While the performance of Windows 8 is embarrassing, it has also set the bar very low for Windows 10 and it is here that I am hopeful.
  • Microsoft’s OS versions seem to alternate between disaster and triumph.
  • The excellent Windows XP was followed by the awful Windows Vista which was followed by the superb Windows 7 and then the disastrous Windows 8.
  • I suspect the reason for this is that when Microsoft gets close to a launch deadline for a new product, it starts dropping features and cutting corners in order to make the release date.
  • This results in an awful release that Microsoft spends the next 2 years fixing.
  • Hence Windows 7 was what Vista was supposed to be and there is every sign that Windows 10 be everything that Windows 8 should have been.
  • This combined with the fact that the upgrade to Windows 10 will be free for 70% of the installed base should mean a pretty rapid upgrade cycle making Windows 10 by far the leading version.
  • Having much greater uniformity across the installed base and having the latest code as the leading version will do a lot for Microsoft’s ecosystem ambitions.
  • Windows 10 has a common code base between all of the devices upon which Microsoft software is installed, allowing apps to run across all devices.
  • This will significantly increase the attractiveness of developing apps for Windows devices as the addressable market will be that much bigger.
  • Furthermore, a common code base will ensure that the ecosystem is more recognisable, easier and more fun to use regardless of which device the user is currently logged onto.
  • The main thrust of Microsoft’s ecosystem strategy is to offer great Digital Life and Digital Work services on every platform and over time entice the user to come back to a Microsoft device.
  • If the entire business moves towards subscription (Xbox Live and Office 365 are examples), the operating system sale will become less and less important.
  • Finally, as Windows 8 is one of the least successful releases in Microsoft’s history the bar has been set very low for Windows 10.
  • With low expectations and a favourable environment, Windows 10 should be a catalyst that begins to allow Microsoft to realise its potential.
  • Microsoft and Google remain my top choices in the digital mobile ecosystem.

Apple Pay – Pulling teeth.

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Apple Pay problematic but better than the rest.

  • Payments are horribly difficult.
  • From vested interests to proprietary standards and a myriad of complexities, getting a mobile payments system to work is a herculean task.
  • This is why I suspect that Apple Pay is experiencing teething problems
  • Research firm Phoenix has conducted a survey that found of the people who had enrolled in Apple Pay only 59% has actually tried to use it and two thirds of those had experienced some difficulty in effecting the transaction.
  • In many cases it was due to the merchant itself not being ready to support the service despite being on the list of those that are supposed to be enabled to do so.
  • Other issues involved the terminal not working, the transaction taking too long and timing out and inaccuracies when the transaction was posted.
  • In many cases the cashier was unable to help fix any of these problems.
  • To be fair to Apple, none of these problems appear to be its fault, highlighting the problem of being dependent on operationally much weaker partners.
  • This combined with weaknesses in how the banks authenticate cards added to the iPhone are all causing the service to underperform the magical experience promised by Apple.
  • I suspect that these problems will eventually be ironed out but it will take a long time as the payment industry is slow moving at best.
  • This gives the alternative offerings more of a chance but they are in far worse shape than Apple Pay.
  • For example, Google Wallet has been around for a number of years but the user experience is so bad that it has never gained any traction.
  • Very like 2009 where every man and his dog created an app. store, now every man and his dog are creating payment services.
  • Almost all of them are likely to fail badly.
  • These services are extremely difficult to get right as one has to line up the entire payment chain from device to merchant to processor to bank.
  • Furthermore this all has to be linked with very secure, very robust, easy and fun to use software.
  • When it comes to fixing all of the back end systems and getting all of the different players on board, the alternative offerings are all miles behind Apple Pay.
  • Consequently, I think that Apple Pay will get it right long before any of the alternatives do, meaning that its position as the payment provider to iOS users is pretty safe.
  • Although Apple has 40% market share in the US, its global average is much lower at around 16.5% meaning that more than 80% of the mobile payment opportunity will still be on the table even when Apple gets it right.
  • I continue to see Apple Pay as a catalyst that stimulates the payment opportunity for others rather than something that takes over the world.
  • Hence, I see big opportunities for other players but progress to date is going to make them followers rather than leaders.
  • Microsoft and Google remain my favoured ways to gain exposure to the digital and mobile ecosystem.