Snap Inc. – Troublesome hardware.

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Another plan that failed.

  • With the reorganisation of its hardware division, Snap Inc. is admitting that it made a wrong turn with its spectacles which despite being cool, no one bought.
  • Steve Horowitz will now become president of technology and report to the chief strategy officer rather than the CEO in what can only be a significant demotion.
  • A large part of the marketing effort has also been terminated with the COO of hardware, Mark Randall presiding over the vestigial remains.
  • Despite being viewed as pretty much the coolest wearable device available, Snap Spectacles only managed to rack up around $5m in revenues during Q2 17.
  • This clearly indicates that hardware was running at a substantial loss and with no turnaround in sight inevitably resulted in the cuts we have just witnessed.
  • All references to becoming a camera company have now been quietly deleted leaving the company at a dead end when it comes to hardware.
  • As Google and Facebook are finding, doing hardware when one is a software company is much more difficult than it sounds and I would not be surprised to see Snap quietly drop this idea completely.
  • This leaves Snap with little differentiation over Facebook which remains its biggest problem.
  • Instagram has a habit of copying all of Snap’s best innovations and pushing them out to its much larger user base pretty quickly.
  • This makes it extremely hard for Snap to compete as apps that offer communication are all about the network of users.
  • Metcalf’s Law of Networking states that the utility or value of a network increases by the square of the number of devices attached to it.
  • This would imply that Instagram should be at least 16x more valuable than Snap meaning that at Snap’s valuation, Instagram makes up more than half of the valuation of Facebook.
  • Instagram is an important part of Facebook but I don’t think it is contributing more than 50% of Facebook’s value.
  • Hence, I would be inclined to believe that Snap remains meaningfully over-valued.
  • I think that fair value for Snap remains around $12.40 per share which is still 10% below where the shares are today.
  • I still think that negative sentiment could push the shares closer to $10 at which point acquirors could start to take interest.
  • Until then I still see no reason to get involved and would strongly prefer Twitter to Snap Inc. (see here)

Wearables – No show

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Adding LTE to Apple Watch is pointless.

  • The problem with wearables that I described nearly 4 years ago (see here) of a solution looking for a problem continues to plague wearables with Fitbit struggling along, sector consolidation and even Apple seems out of ideas.
  • If the rumour machine citing endless anonymous sources is to believed Apple’s next version of the Apple Watch will feature a LTE modem.
  • This will give the device independence from the iPhone, meaning that the user won’t have to have the iPhone in immediate proximity for the device to work.
  • I think that putting a LTE modem is pointless and could even harm what little appeal the product has.
  • This is for two reasons:
    • First: In the US (I suspect Europe is similar) users are now glued to their smartphones for an average of 300 minutes per day (Flurry).
    • This essentially means that users keep their smartphones in their immediate vicinity at all times and will go to great inconvenience to ensure that that remains the case.
    • As a result, there is only a tiny period (if any) of time when the smartphone is out of Bluetooth range of the user and hence any wearable that he has on him.
    • Therefore, the inclusion of a cellular modem will be able to improve the functionality of the Apple Watch for only a tiny percentage of the user’s day.
    • This renders it effectively useless in my opinion.
    • Second: A LTE modem (even with a soft SIM) is going to cost money, take up space that could be something used for something else and will be a net drain on the battery.
    • Battery life is a major issue for all wearables (including the Apple Watch) and the addition of a modem will place a further drain on already very limited resources.
    • Hence, I think that a modem will cause deterioration of the user experience for no perceptible improvement.
  • What Apple should really be working on is a use case or function for this product that makes it a must have causing everyone to rush out and buy it.
  • This is the genius for which Apple has been known in the past but of which there has not been much sign over the last few years and certainly not with this product.
  • Consequently, I hope that like the large screen TV and the vehicle, this product never sees the light of day.
  • Instead, I am looking for a use case that can really kick start the wearable market as without this spark of genius, it is likely to continue bumbling along with little real interest or volume.

Digital sensors – Eyes and ears.

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Sensors are the eyes and ears of AI.

  • Data is the raw material of artificial intelligence (see here) meaning that will be increasingly critical that the sensors that collect that data are reliable and accurate.
  • Nowhere is this more true than in eHealth where inaccurate data is useless at best and deadly at worst.
  • This is why there is still a big market for extremely expensive medical monitoring equipment but I see signs everywhere that this is starting to come to an end.
  • This also explains the problems that the likes of Fitbit, Apple, Xiaomi, Garmin and others are having as the data they generate is such low quality that it can really only be used for recreational fitness.
  • I see two ways in which the data that these sensors generate can be improved.
    • First: Improve the quality of the sensors themselves.
    • If an optical heart rate sensor can gather data as reliably and as accurately as an ECG, then this would have substantial ramifications for cardiac medicine.
    • Not only could the equipment costs be slashed, but high-risk patients could be continuously and un-invasively monitored allowing many cardiac events to be predicted and stopped before they occur.
    • The sensor industry is feverishly working on this with the latest launches promising more and more accuracy and detail.
    • Despite this, I have yet to meet a cardiac sensor company that is claiming that it can hit the kind of quality that would allow it to be certified with the FDA.
    • The same is not true in blood pressure where small start-up Leman Micro Devices is making some bold claims.
    • It has come up with a tiny blood pressure sensor that can fit onto a smartphone which it thinks is very close to being good enough to measure blood pressure at a medical grade with FDA approval.
    • Second: create intelligent software that improves the quality of the data.
    • There are many examples of algorithms being used to meaningful conclusions from low quality data both in and out of the medical field.
    • In automotive, retro-fitted vibrations sensors are being used to track the condition of tyres, wheels, shock absorbers, brakes and the steering wheel (see here and here).
    • This is not because a great sensor has been invented, but because these companies have worked out to interpret the data that most people consider to be random noise.
    • Phillips is also quite good at this which is why its health watch is recognised to be generating good quality data even if it does struggle in other areas.
  • Hence, I see the road to accurate data being made by eroding the problem from both ends combining both better hardware sensors and much better software to interpret the signals.
  • I think that this is crucial as sensors are the eyes and ears of the machines upon which the world increasingly depends.
  • Consequently, I think that sensors will remain an area of intense investment and an area where I would want to be invested.
  • The issue of course is to separate the solutions that have real prospects from those that are merely riding the wave of hype and easy investment.

 

Wearables – Holding pattern

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Wearables are sitting in a holding pattern. 

  • Amazon, eBay and Google (Maps) have ceased supporting their apps on the Apple Watch, confirming my suspicions that while it may be novel to shop and navigate from the wrist, it is neither useful nor fun.
  • I see this as yet another sign that smartwatches and wearables remain in limbo as they are a solution looking for a problem explaining why most users tire of them so quickly.
  • That being said, I think that wearables and smart watches have found a niche in the recreational fitness market which looks to have bottomed out after a very difficult period in the middle of 2016.
  • The market returned to growth in Q4 16 with 25% increase in volumes YoY but it was the cheap and cheerful providers that made all of the running with Xiaomi, Samsung and the others accounting for the vast majority of the increase.
  • To make matters worse, these are already commodity products with most priced well below $100 where no one is making a sustainable return.
  • The market leader Fitbit saw a 23% decline while Apple Watch grew by 13%.
  • I think that the reason why there is so little differentiation remains that no one has really figured out how to make a wearable product a must have.
  • Even Apple, which has a legendary ability to come up with compelling use cases, has struggled and the main question asked by potential users is: “Why would I buy it?” rather than: “How much is it?”
  • Outside of fitness tracking, wearables are little more than remote controls for a smartphone providing no reason to shop or navigate from these devices.
  • This is why I suspect that Amazon, Ebay and Google Maps have dropped support although Google has said that it “intends” to support Apple Watch once again in future releases.
  • I would be not surprised to see other third parties drop support for the Apple Watch as there are costs involved with development which don’t seem to have shown any tangible benefit to the developer.
  • I think that one of two things need to happen to make this segment blossom:
    • First: Devices become capable of delivering medical grade health measurements.
    • For blood pressure and blood glucose alone this would open up a market of 1.4bn users.
    • There are some signs of this among the start-up community but there is still some way to go.
    • Second: A must have use for these devices has to be found.
    • I am not confident as this has been Apple’s great strength to date but even it has failed when it comes to the Apple Watch.
  • Hence, I think that Wearables will bumble along the bottom with very low profitability until one of these criteria is met.
  • I can’t say that I would be keen to invest in anyone with exposure to this difficult and non-profitable segment.

Fitbit – Boredom bites.

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User indifference likely to drive further estimate cuts in 2017.

  • Fitbit issued a horrible profit warning as users appear to be becoming bored with fitness tracking despite Fitbit’s efforts to drive engagement through the ecosystem.
  • Q4 16A revenues / Adj.EPS will be $572m – $580m / LOSS$0.51 – LOSS$0.56 compared to previous guidance of $725m – $750m / $0.14 – $0.18.
  • The new revenue estimate is 22% below where the company thought demand would be in Q4 16 and 27% below the consensus estimate of $736m.
  • The company also took the knife to its 2017 estimates with revenues / Adj-EPS of $1.5bn – $1.7bn / LOSS$0.22 – LOSS$0.44 compared with consensus at $2.38bn / $0.43.
  • The company blamed market softness for the shortfall and promised a recovery in H2 2017 but only because the year over year comparisons are much easier given the awful H2 2016 the company has had.
  • I think that Fitbit has three major problems:
    • First: It’s sensors are not accurate enough to be of any use beyond recreational health.
    • I believe that all health trackers suffer from this problem and until these devices are far more accurate, they will all have difficulty in expanding into the huge opportunity represented by health monitoring.
    • Phillips makes some bold claims in this area but I have yet to see hard evidence that its products are meaningfully more accurate than anyone else’s.
    • Second: The issue with wearables being a solution looking for a problem (see here) appears to be getting worse.
    • This is because the health tracking that these devices offer is simply not good enough and hence many devices end up gathering dust in a drawer after a couple of months.
    • Fitbit does far better than most but with only 23.2m active users of its devices, there are still a large number of devices out there that are no longer on the wrists of users.
    • Furthermore, from an ecosystem perspective, Fitbit is still miles adrift of the 100m active users that RFM estimates are needed for an ecosystem to hit critical mass.
    • Third: Fitbit is being eroded from both ends with Apple Watch at the top of the market and cheap Chinese health trackers at the bottom.
    • This issue is exacerbated by the fact that Fitbit has offered no real innovation in health tracking for some considerable time which has meant that the cheaper Chinese versions are just as good in terms of generating raw data.
    • If Fitbit was able to reliably track calorie consumption, blood pressure or blood sugar, then this would give it something with which to fight back against commoditisation, but of this there is no sign.
  • On top of the warning, Fitbit has also pledged to cut $200m of OPEX in 2017 with way less than 10% of this coming from headcount.
  • This means that certain aspects of sales and marketing and some research and development projects are also going to be cut.
  • This will make it even harder for Fitbit to come up with a winning innovation with which to restore its gross margins.
  • Consequently, the outlook for Fitbit in 2017 looks very difficult and I suspect that it may be taking the knife to its estimates yet again in 2017.
  • Just like GoPro, Fitbit remains one to be assiduously avoided in 2017 as both have further to fall leaving them open for acquisition (see here).

Fitbit and GoPro – Horrific Halloween

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I see acquisition as the endgame for both players. 

  • GoPro and Fitbit have both been hit again by the simple fact that their products are commoditising and that they have been late to generate user stickiness through the ecosystem.
  • Fitbit reported Q3 16A revenues / adj-EPS of $504m / $0.19 compared to estimates of $508m / $0.19.
  • However, guidance for the critical Q4 holiday season missed estimates by 25% with Q4 16E revenues / adj-EPS of $725m – $750m / $0.14 – $0.18 compared to forecasts of $981m / $0.75.
  • Soft demand and some production issues were blamed for the shortfall but at the end of the day it is increasingly clear that Fitbit’s products are commoditising fast.
  • GoPro fared little better with Q3 16A revenues / adj-EPS of $241m / LOSS$0.60 some 22% below forecasts of $310m / LOSS$0.37.
  • GoPro also went on to say that Q4 16E would also miss estimates with revenues of $600m – $650, some 8% below what the street was looking for.
  • GoPro blamed production issues around the Hero 5 black for the shortfall but I can’t help wondering how many users bought the perfectly good, and 37% cheaper, YI 4K Action Camera instead.
  • YI (Xiaoyi in China) is also coming out with a drone which will carry its 4K camera like the Karma does and this too, will be a t a substantially lower price.
  • Furthermore, when one looks at Fitbit, sales in Asia were down 45% in Q3 16A primarily as a result of a plethora of cheap and adequate health tracking products from Chinese brands such as Xiaomi.
  • These are the issues that beset both Fitbit and GoPro which could have been avoided if they had begun development of their ecosystems much earlier.
  • Unfortunately, like most companies that experience sudden and rapid growth, they have become reactive rather than proactive which is what has landed them in this pickle.
  • If GoPro and Fitbit users knew that they would have an easy to use, fun and vibrant ecosystem to enhance their health monitoring or home movie experience, they would want to stay rather than experiment with far cheaper Chinese equivalents.
  • Both seem to have cottoned onto this concept now but they have only done so once they got into trouble which is much too late.
  • This means that their ecosystems are neither mature enough nor large enough to provide the kind of stickiness that they so desperately need.
  • The result is that users don’t seem to mind leaving to try something else as they have nothing invested in these companies beyond the hardware.
  • Without that critical stickiness, GoPro and Fitbit have to compete on price which is something they cannot afford to do given their high cost base in developed countries.
  • This is why I fear the end game for both of these companies is acquisition.
  • Their hardware is excellent but users are increasingly not willing to pay a premium for it, meaning that gross margins and revenues are going to come under sustained and intense pressure.
  • Someone with a strong ecosystem such as Apple, Google, Tencent, Alibaba or Baidu could easily pick these companies up and combine their good hardware with their own ecosystems to make them much stickier.
  • However, in the absence of M&A, the outlook is very bleak indeed and their shares are likely to continue to suffer from heavy selling pressure.
  • The question is at what point do the shares sink so low that the acquirers are flushed out?
  • I suspect the answer is lower than where we are today.

Wearables – Deadly drift.

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Still, no one knows why they should buy one. 

  • Apple Watch 2 has failed to revive the flagging smartwatch market in yet another sign that wearables remain a solution looking for a problem.
  • The latest data from IDC shows that the smartwatch market (a subset of wearables) declined by 51.6% YoY in Q3 16 with Apple Watch shipments declining by 71.6% to just 1.1m units.
  • The overall wearables market is growing around 25% but it is the cheap and cheerful pedometers and basic fitness trackers that are making all the running.
  • To make matters worse, these are already commodity products with most priced well below $100 where no one is making a sustainable return.
  • I think that the reason why there is so little differentiation remains that no one has really figured out how to make a wearable product a must have.
  • Even Apple, which has a legendary ability to come up with compelling use cases, has struggled and the main question asked by potential users is: “Why would I buy it?” rather than: “How much is it?”
  • Fitness tracking is already a commodity and one with which many users rapidly tire.
  • Health tracking is also in its infancy as the sensors are still not close to being good enough to provide safe and secure health monitoring although Philips is making every effort to make its devices medical grade.
  • Outside of that, wearables are little more than remote controls for a smartphone providing no reason for mass market adoption.
  • The market will grow this year but at a much slower rate than the triple digit growth it experienced in 2015
  • Furthermore, the value of the market will be very challenged with brutal price erosion potentially driving the value of the market into negative territory.
  • Of all the wearable players, Apple is likely fare by far the best as it has a very strong ecosystem which is critical to ensure differentiation.
  • Even Fitbit, which currently leads this market, is likely to struggle as it does not have the scale nor the experience outside of fitness tracking to put together a user experience compelling enough to keep its gross margins where they are.
  • Hence I think that 2017 will be even more difficult for wearables in general as the ravages of commoditisation bite despite some unit growth.
  • Apple is the only company with exposure to this market that has the capability to maintain its pricing and not feel the problems of this market in its income statement.
  • Microsoft, Tencent and Baidu are my top picks but I think that Apple remains a safe place for long term income based investors.

Fitbit Q2 16A – Breathing space

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Fitbit has earned time to develop its ecosystem. 

  • Fitbit reported good Q2 16A results as demand continues to be steady while the company works on its ecosystem.
  • Q2 16A revenues / adj-EPS were $586.5m / $0.12 compared to consensus at $578.2m / $0.11.
  • 7m devices were shipped (up 27% YoY) which was particularly encouraging given Apple’s 50% decline YoY.
  • Although life is much tougher now than it was 12 months ago, Fitbit is still profitable and is generating cash meaning that it will be able to launch new products as well as work on its ecosystem.
  • Although most attention remains on the hardware, it is the development of the ecosystem that will determine whether Fitbit thrives or withers.
  • The vertical that Fitbit has chosen is digital health and wellness which makes sense given that the only success that wearables have really found to date is within this segment.
  • The idea is to get users to upload, share and analyse their data in the cloud such that they become more engaged and use the device more.
  • Wearables suffer greatly from users getting fed up with them and leaving them to gather dust in drawers which is something that Fitbit must address.
  • it has been much better than its competition at keeping users engaged. but still only a small percentage of the 49m devices that Fitbit has shipped to date are still in use.
  • If Fitbit can keep its users engaged and generating data, then it users will choose its devices when they come to upgrade giving it the ability to earn better margins.
  • Furthermore, if it can become a go to place to store health and fitness data, it could expand into other device types along the same sort of lines and users will have a strong incentive to stay.
  • Its chief competitor in this space is Apple with its HealthKit API but given that 87% of the world and more than 50% of USA do not use an iPhone, there is enough space for Fitbit to grow into.
  • Despite the stabilisation at Fitbit, its guidance for the full year continues to look very ambitious.
  • Fitbit earned adj-EPS of $0.22 in H1 2016A, and is guiding for $0.17-$0.19 in Q3 16E and $0.72-$0.84 in Q4 16E.
  • Fitbit is very dependent on the holiday selling season and I think it will have difficulty in meeting the very heavy year end expectations.
  • With the shares on 25x 2016E PER, there is not much room for error and it will be some time before its fledgling health ecosystem gains critical mass.
  • Hence, I would be inclined to wait before looking at this one seriously again.
  • That being said, I would have it in a heartbeat should I be forced to choose between this, GoPro and HTC.

Wearables – Wrong direction

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Precipitous decline underscores the problem. 

  • It looks like demand for smartwatches has precipitously declined in Q2 16A, taking the overall outlook for wearables with it.
  • To me this is just another signal that the market is not ready for wearables mostly because no one has really figured out what to do with them.
  • Data from IDC (see here) is indicating that demand for smartwatches fell by 32% to 3.5m units in Q2 16A mostly driven by a decline in Apple Watch shipments to 1.6m units from 3.6m shipped right after its launch in Q2 15A.
  • Given that smartwatches are around half of the total market for wearable devices it is easy to see how the entire market could easily decline this year.
  • These figures bring into sharp focus the problem with wearables which is that no one really has any idea what to do with them meaning that most users are just not that interested.
  • To make matters worse, I can’t see this problem being fixed anytime soon.
  • The one exception to this is e-health where enabling users to track certain biometric characteristics could have substantial benefits for disease diagnosis and prevention.
  • Unfortunately, none of the devices are able to do this with anything like the kind of accuracy or reliability that would make it safe to rely on the data.
  • I have long thought that inaccurate health data is bad at best and dangerous at worst and so I do not see any real threat to the medical devices industry for now.
  • Currently, wearables are good enough to monitor biometric data for recreational and basic fitness uses but nothing more.
  • This makes a wearable nice to have but it still means there is no burning reason why a user must have one of these devices.
  • This has been echoed in Apple stores, where the Apple Watch tables are the least visited and the most asked question is “why should I buy one?”
  • This is why shipments of Apple Watch have been so far below bullish forecasts and why many users stop using a wearable within three months of purchase.
  • Consequently, I continue to think that wearables are little more than remote controls for a smartphone providing no reason for mass market adoption.
  • Of all the wearable players, Apple is likely fare by far the best as it has a very strong ecosystem which is critical to ensure differentiation.
  • Even Fitbit, which currently leads this market, is likely to struggle as it does not have the scale nor the experience outside of fitness tracking to put together a user experience compelling enough to keep its gross margins where they are.
  • Hence I think that 2016 will be very difficult for wearables in general as the ravages of commoditisation bite against a backdrop of increasingly indifferent users.
  • Apple is the only company in this space that I would consider investing in but its exposure to wearables is tiny relative to its market capitalisation.
  • Hence, wearables is not a theme in which I am looking to have exposure to for the balance of 2016.

 

Fitbit Q1 16A – Forced hand.

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Fitbit is being forced to spend to stay ahead.

  • Fitbit reported good Q1 16A results but cut guidance in order to ramp up spending placing unrealistic expectations of profitability in H2 2016.
  • This is particularly worrying as there are clear signs that commoditisation is forcing the company to increase spending, hitting profits.
  • Q1 16A revenues / adj-EPS were $505m / $0.10 nicely ahead of consensus at $443m / $0.03 but EPS for the quarter ahead is going to be weak.
  • Q2 16E revenues are expected to be $565m-$585m ($575m midpoint) ahead of consensus at $533m but expectations of adj-EPS at $0.08-$0.11 are way below consensus of $0.26.
  • Gross margins are slipping as commoditisation creeps in but the real problem is OPEX.
  • Fitbit is right in that it needs to spend on R&D and sales and marketing to stay ahead of its rivals, but general and admin expenses (G&A) are a real worry.
  • In Q1 15A G&A expenses were $13.0m or 3.9% of sales but in Q1 16A they jumped to $35.7m or 7.1% of sales.
  • My threshold for G&A is 5% and this sudden elevation has all the hallmarks of indisciplined expansion.
  • This in turn makes me worry about the quality of the investments that the company is making in both R&D and sales and marketing.
  • If these investments do not produce results, then commoditisation will accelerate and gross margin will continue to decline hitting the already fragile profitability.
  • The good news is that Fitbit knows exactly what it has to do which is to increase the stickiness of its users through the refinement of its embryonic ecosystem.
  • This alone puts Fitbit miles ahead of GoPro when it comes to dealing with aggressive competition and slowing and saturated end markets.
  • When it comes to an ecosystem the key is the number of users and the degree to which they are engaged with one’s services.
  • Fitbit posted some encouraging figures at its 2015 year end results in January with 16.9m active users making up 59% of the registered user base.
  • These users were also more engaged with an average of 7.5 connections to other users compared to 4.9 at the end of 2014.
  • Unfortunately, Fitbit declined to update these figures leading me to believe that there was nothing particularly good to report.
  • This is concerning because if the investments that it is making in R&D and sales and marketing pay off, it is in user numbers and engagement that the results will be first seen.
  • Gross margin stabilisation and profits will then follow but it is in the ecosystem where the loyalty and preference will be generated that will give Fitbit pricing power.
  • Somewhat inexplicably, Fitbit also raised its adj-EPS guidance for the full year to $1.12 – $1.24 from $1.08-$1.20 meaning that to meet guidance Fitbit needs to generate 83% of its net profit in the last 6 months of the year.
  • Given the environment, this looks to be a very tall order and I suspect that there is a heavy cut to full year EPS guidance coming either in June or October.
  • My concerns around both the market for its products and its fiscal discipline lead me to believe that Fitbit could realistically generate adjusted EPS of $0.80 for the full year.
  • This leaves the company with a 2016E PER of 18.5x which is quite punchy for a company showing little profit growth and at high risk of commoditisation.
  • I would be more comfortable between $10-12 a share rather than the $14.90 that it is currently at but if forced to choose I would have this over GoPro.