Search Follow us
13 December 2017

Broadcast TV - Sword of Damocles pt. IV

Cable TV looks finished while OTA has another chance

The nominations of the Golden Globes have revealed further gains for the OTT players over the traditional content creators also signalling the coming demise of cable TV. The nominations for the 2018 Golden Globe awards have been published where the TV section makes interesting reading. Out of a total 55 nominations, 15 (27%) went to TV shows that were exclusively owned and distributed by streaming services. This is a big increase from last year where 10 (18%) out of 56 nominations went to shows owned by the streaming services.

However, 2017 has seen real differences emerge between the streaming players with Netflix pulling away from its competitors Amazon and Hulu. In 2016 Netflix and Amazon were neck and neck on 5 nominations each but this year Netflix has gone up to 9 (behind HBO on 12) while Amazon has fallen to 3. We suspect that this is a reflection of the big increases in content spending that Netflix has made which grew to $6bn in 2017 and $8bn in 2018. However, while Netflix is gaining ground on the traditional content creators, its catalogue is really suffering as other content creators are increasingly pulling their content from its catalogue and going on their own.

The latest is Disney which aims to start its own streaming service in 2019. Netflix started life as a distributor of DVDs and was early into streaming, but as it has rightly identified content as the future, it earned the ire of the rest of the entertainment industry. The result could end up being a series of streaming services all with exclusive content from which consumers can pick and choose their subscriptions. To us, this is the death rattle of the cable TV industry. A standard cable TV subscription in 2016 cost on average $103.10 per month for which a large number of channels come as a prepaid package. However, in reality, most users watch only a few of those channels meaning that it if they could subscribe to those channels individually, they would be in a position to save a lot of money. With the content creators all fragmenting into their own streaming services, this is exactly what seems to be happening and we suspect that the amount of money spent on premium TV in USA is going to fall meaningfully.

This is likely to be a death sentence for both the cable TV companies and the smaller channels that ride on the coat tails of the big channels. This is because they are receiving income from the all in one subscription payment despite having very few viewers. At the same time there appears to have been a substantial recovery in the number of households making use of OTA (over the air broadcast). According to a Nielsen study commissioned by Ion Media, OTA only households has grown by 41% over the last five years to 15.8m households although this may have slowed significantly since 2015. Furthermore, this is not limited to older generations as the median age of households using OTA and not cable is lower at 34.5 years than the total households using TV at 39.6 years. Although the total number of households switching back to OTA-only may have slowed, there has been real growth in households that also have a fast broadband connection. This leads us to believe that users (young and old) are increasingly switching off cable and replacing it with a combination of premium streaming services and OTA TV.

This allows the user to have access to a wide range of channels representing almost all the content he was watching on cable at a much lower price.  Consequently, while commentators are cautious on the outlook for TV advertising revenues in 2018 and beyond, we think that they could easily witness a recovery having been stalled for some time. We suspect that this is a temporary trend as the spectrum that OTA currently occupies could be re used for much more valuable services as there is no reason why OTA cannot be streamed just like everything else. The obvious move is to make the entire selection of channels available on a single, free, ad-supported streaming service.  If it is really sharp, OTA will also seek ways to make its offering available in emerging markets which are highly price sensitive and willing to consume advertising in lieu of paying a subscription.  Hence, we think that the era of one big subscription is coming to an end and consumers are likely to end up spending less money while still getting exactly the channels that they want without having to indirectly pay for any more. We see cable cutting accelerating significantly in 2018 with real industry change coming in 2020 and beyond.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

11 December 2017

Qualcomm & Microsoft – Dream with caveats.

Some space left for this proposition

Windows on ARM is back for another crack at the PC market and while we can see a place for it, it is unlikely to cause Intel too much grief. Microsoft and Qualcomm have launched a series of laptops that are running Windows 10 on Qualcomm’s SnapDragon 835 chipset. In addition to offering better battery life, the presence of the chipset enables the always-on functionality and connectivity that users are used to with smartphones and tablets. If that were all that there was to this story, then we would be pretty sure that Qualcomm would quickly take over the PC market but, as always, the devil is in the details.

Many of the devices will ship with Windows 10S (for which they are best suited) but will be upgradeable to the full version of Windows 10. Microsoft has compiled Windows 10, Edge and shell to run natively on ARM and had also recompiled a series of DLLs (dynamic link libraries) to ensure that the major desktop applications run properly. For everything else, Microsoft has created an emulator (generally a big drain on performance) that will allow other third-party apps to run with some exceptions. These are: 64bit apps won’t work yet, kernel mode drivers are not supported which means that most antivirus and games that use DRM or anti-cheat software won’t work properly.

This means that buyers of these devices will not be able to be 100% certain that everything they might want to run will work. We see this as a big sticking point, as failure to perform as expected will infuriate users and create a lot of bad press around these products. This is the same concern that we had around the launch of Windows 10S which makes some sense in the classroom but nowhere else. These devices need to perform as well as Intel devices in their pricing tier otherwise buyers are likely to be put off. Given that Intel has much higher gross margins than Qualcomm in silicon, this might be achievable, but it will also depend on the quality of the implementation by the PC makers themselves.

The PC market has changed dramatically over the last few years as casual users have deserted the platform. This is because, these users predominantly used a PC for browsing, email and media consumption and smartphones and tablets offer a more convenient and better way to conduct these activities. Consequently, these users have ditched the PCs that they owned and replaced them with smartphones and tablets instead. It is this that have long believed has been mostly responsible for the softness that has been observed in the PC market over the last 5 years. This trend also means that the users that are left are much more focused on the functions that PCs do really well like content creation and high-end gaming. For these users, performance is critical, and we suspect that Windows 10 on ARM will not be powerful enough for them.

This leaves Windows 10 on ARM somewhat in limbo but for students, schools and very price sensitive users, this may represent a good option. Hence, if Intel is going to feel any heat from this, it is going to be at the very low end of the market which is not where it makes most of its money. The amount of traction that these devices get depends mostly on their price and the quality of the implementation by the PC makers but we think that it is pretty clear that the performance driven end of the PC market is almost certain to remain Intel’s.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

7 December 2017

Google & Amazon – Battle for the smart home

We don’t think Google will go out of its way to patch things up with Amazon as having YouTube absent from Amazon devices could disincentivise users from going with Echo products giving Google Home a badly needed boost. Google and Amazon have been sparring for several months but the move by Google to pull YouTube off Amazon ecosystem devices may bring this issue to a head.

It is also a demonstration that content is king and as of today, YouTube is amore important platform than Amazon Prime Video.  Consequently, Amazon needs YouTube on its devices more than Google does as users will simply go elsewhere to get it.  This sparring began three months ago when YouTube pulled its native support from the Amazon Echo Show. This was followed by the removal of Nest products from the Amazon website and the implementation of a clumsy and far from ideal workaround to get YouTube content back on the Echo Show. Google has closed this loophole as of today and will also pull support from Fire TV from 1 January.

This battle between Amazon and Google is peripheral to their core businesses as even in video, they do not really compete directly. YouTube is an encyclopaedia of user generated content while Amazon Prime Video is just like Netflix. Google does have YouTube Red but this is a tiny part of YouTube overall. Consequently, this fight is all about the home and here Google is way behind Amazon despite having the better product. This is because Amazon has been much better showing developers love and as a result they have preferred to develop their smart home products for Amazon Alexa. The result has been that almost every device sold will work with Alexa with only a few working with Google. This has changed over the last 6 months but Amazon’s ability to advertise its products on its website as well as giving its cheapest product away for free has allowed it to maintain its lead.

With the critical holiday selling season upon us, this is a great time to throw a spanner into Amazon’s works as not working with Google services is going to be a problem for the vast majority of users and may push them to consider Google Home. We still see Google as being on the back foot when it comes to the smart home but it has closed some of the gap to Amazon in terms of third parties and it remains a superior product. This will be a key battle that is played out in 2018 and the level of support offered by device and service developers when they show their wares at CES in January will be a key indicator. The market remains very lowly penetrated and so there is everything to play for but we think that in the long-run Google should win as it has the better product. We will revisit this position again once it becomes clear which way smart home developers are inclining for their 2018 product launches.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

6 December 2017

Xiaomi – Market timing

Xiaomi considers a market event just as growth peaks again

Xiaomi’s genius for timing is confirmed as talk of an IPO is beginning to ramp up just as its recovery growth rates are about to peak. However, this time around, profitability will be open and clear for all to see and it is here where the problems will arise. To be fair to Xiaomi, it has executed extremely well and has been rewarded with a period of very rapid growth as its strategy to distribute through methods other than the Internet and to focus on India has paid off in spades.

Xiaomi’s performance really turned around in Q2 17A where YoY growth in smartphone shipments went from -8% in Q1 17A to 59% YoY in Q2 17A. This was a result of big changes implemented by Xiaomi. The new flagship Mi 6 launched at the beginning of the quarter was well received and looks to have been the backbone of the recovery. We have long been of the opinion that Xiaomi ground to halt because it had fully exhausted the capacity of selling devices over the internet. In order to address a wider slice of the market, Xiaomi has invested heavily in retail with 123 MI stores opened across China and the first results from this push are now being seen in the numbers. Investments in India are beginning to pay off with the Redmi Note 4 becoming the biggest volume smartphone in Q2 17, elevating Xiaomi to No. 2 in India.

By far the largest part of Xiaomi’s overseas fan base is to be found in India and this should help the fan base to grow further. However, India can be one of the most fickle markets as it is so price driven and as many Indian brands have found, success can be all too brief. While growth is clearly back at Xiaomi, the comparisons to the torrid time it had in 2016 are really easy as after Q2 2018, growth is likely to slow substantially as the comparisons to the previous year will become much more challenging. Consequently, sometime in H1 2018 is the perfect time to achieve the best possible IPO price as growth will then be at its highest. However, the big question mark is profit, as it is through profit alone that an equity based investment can have any value at all. Here, we are still very cautious as Xiaomi’s strategy is based on providing good quality hardware at a great price. This combined with the fact that it does not have Samsung’s scale in handsets means that it is very unlikely to make more than a commodity margin.

When we are as kind as we can be to Xiaomi, we can assume that its smartphone ASP is $270 on 118m units shipped in 2018 with $5.4bn in revenues from smart home products. Assuming an EBIT margin of 5%, this gives 2018 revenues / EBIT of $37.31bn / $1.87bn implying an EV / Sales multiple of 1.3x and EV / EBIT of 26.7x if the company is valued at $50bn. For an EV / Sales valuation, this is not difficult to reach as Apple is trading on 2018 EV / Sales of 2.7x and Xiaomi is growing faster. However, equity valuation is about profit with revenues being used as proxy when there are no profits. Using EBIT, a very different picture emerges as Apple is trading on 8.4x EV / EBIT and at $50bn, Xiaomi would be on 26.7x. Xiaomi is growing faster than Apple but this is unlikely to last very long and its efforts to build a software ecosystem have been crushed by the BATmen at home and are irrelevant overseas. Hence, it has very little with which to differentiate its wares meaning that it has to compete almost entirely on price.

Consequently, the most we would be willing to even remotely consider paying for Xiaomi would be double Apple’s EV / EBIT multiple which would give a valuation of $31.3bn, some 37% below the mooted $50bn.To get to $50bn, Xiaomi would need to put up EBIT margins of at least 8.0% which is a stretch given the company’s strategy of selling great hardware at good prices. The advantage of an IPO is that these facts will all be laid bare long before investors have to commit to buying the shares. We suspect that its lack of profitability will keep it from going public until it is capable of putting up much bigger profit numbers.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

5 December 2017

Google - Brain game pt. II

Google remains out front in AI but Baidu most interesting.

The first results from Google’s AutoML project are beginning to surface and are implying once again that machines may end up being better coders than humans.
AutoML was announced at Google i/o in May 2017 and failed to attract much attention mainly because most commentators did not grasp the significance of the concept. AutoML is neural network that is capable selecting the best from a large group neural networks that are all being trained for a specific task. This is potentially a hugely important development as it marks a step forward in the quest to enable the machines to build their own AI models.

Building models today is still a massively time and processor intensive task which is mostly done manually and is very expensive. If machines can build and train their own models, a whole new range of possibilities is opened-up in terms of speed of development as well as the scope tasks that AI can be asked to perform.  In the subsequent months since launch, AutoML has been used to build and manage a computer vision algorithm called NASNet. AutoML has implemented reinforcement learning on NASNet to improve its ability to recognise objects in video streams in real time. When this was tested against industry standards to compare it against other systems, NASNet outperformed every other system available and was marginally better than the best of the rest. This is significant because it is another example of when humans are absent from the training process, the algorithm demonstrates better performance compared to those trained by humans.

Big challenges in AI include the ability to train AIs using much less data than today, the creation of an AI that can take what it has learned from one task and apply it to another and the creation of AI that can build its own models rather than relying on humans to do it. When we look at the progress that has been made over the last year in AI, we think that Google has continued to distance itself from its competition.
Facebook had made some improvements around computer vision, but its overall AI remains so weak that it is being forced to hire 10,000 more humans because its machines are not up to the task. Consequently, we continue to see Google out front followed by Baidu and Yandex with Microsoft, Apple and Amazon making up the middle ground. Facebook remains at the back of the pack and its financial performance next year is going to be hit by its inability to harness machine power. For those looking to invest in AI excellence, Baidu is the place to look as its search business and valuation has been hard hit by Chinese regulation but is now starting to recover. Baidu represents one of the cheapest ways to invest in AI available.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

4 December 2017

Digital Sensors - Heart of the matter

Apple is creeping up on the medical devices industry

Apple has taken wearables a step closer to replacing medical devices, but the user experience is still so limited that the immediate term for the medical, devices industry still looks secure. KardiaBand (AliveCor) is a strap for the Apple Watch which incorporates in it a sensor that is capable of producing a full electro cardiogram (ECG). Critically this accessory has been approved by the FDA meaning that it is good enough to be a medical device producing medical data that can be relied on by a doctor.

The Apple Watch app that comes with KardiaBand can use the heart rate sensor on the Apple Watch to detect abnormalities and recommend to the user that he records his ECG.  Atrial fibrillation is a leading cause of stroke and it is thought that 66% of strokes could be prevented with early detection. It is the signs of this that the KardiaBand app is looking for via the Apple Watch sensor which can then be confirmed through the recording of an ECG. This does not come cheap at $199 for the band and $99 per year for the monitoring service, but if it works as advertised, it is a tiny price to pay for avoiding a stroke.

However, the use case is not ideal requiring a large metal plate to be present in the device’s strap and it does not offer always on monitoring. This combined with its price means that it will only really appeal to users who are known to be at risk from stroke and it does not enable the replacement of an existing medical device. We see the combination of Apple Watch and KardiaBand as a halfway house as it does not really offer real time monitoring to a medical grade, but it is a step in the right direction.

Sensors are becoming the eyes and ears of AI, but almost all sensors are not nearly good enough to produce data that can be used in critical applications. 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 we see signs everywhere that this will eventually come to an end. This also explains the problems that the likes of Fitbit, Xiaomi, Garmin and others are having as the data they generate is of such low quality that it can really only be used for recreational fitness. eHealth is where the quest for accurate data begins but I see this quickly spreading to other industry verticals.

Accurate sensors are one way to attack this problem but the other is to use better software to clean up and improve less-than-perfect data sources. Google is a good example of this as it can use software to produce better imaging effects in portrait mode with one camera than Apple can with two. Given the substantial rewards that are on offer, the investment in improving the quality and accuracy of sensors will only continue to increase in the coming years. This is an area to be involved in. 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.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

1 December 2017

Amazon - Size 12s

Amazon is stomping on Microsoft’s patch. 

With the launch of Alexa for Business, Amazon is stomping with its size 12s all over the territory of its supposed new best friend, Microsoft and its digital assistant, Cortana.
Alexa for Business is expected to be launched next week at the AWS reinvent conference and will allow businesses to build their own skills for the digital assistant that can be used in a work context.  It will also feature all of the normal functionality such as enquiries and smart office and is expected to feature partners like Concur and WeWork at launch.

This has the scope to both generate more skills and applications for the Alexa digital assistant but also to generate increasing loyalty to AWS. Some of these skills are likely to include integration with Office functionality such as calendar management, meeting room scheduling and so on. If this takes off, there is no reason why this should not spread to the desktop and deeper into Microsoft’s core asset Office. The issue here is that Microsoft already has a digital assistant called Cortana, and with Microsoft’s increasingly dominant position in the enterprise, this would seem to be an obvious opportunity for Cortana.

However, Cortana is struggling because it was originally designed to run on Windows Phone meaning that many of the skills that it has been taught are not relevant with the assistant sitting on the desktop. Furthermore, Amazon and Microsoft recently announced a partnership where users will be able to ask Alexa to ask Cortana to do something and vice-a-versa.  Given Microsoft’s focus on the enterprise, we have been under the impression that the future for Cortana would be in the enterprise where it can be deeply integrated into Microsoft’s market leading apps. At the same time, we assumed that the partnership would offer Amazon a way to use Alexa on the PC and in the enterprise.

However, it seems that Amazon is short-cutting its partner by going for the enterprise completely independently of its partnership with Microsoft. The one area where Microsoft has a more relevant product than Amazon is in AI, where RFM has estimated that Microsoft is ahead of Amazon. Consequently, we can see an eventual collaboration where Microsoft’s AI is used to drive Alexa’s services in the enterprise. The only problem here is that this could result in cross over between Microsoft and Amazon Web Services who are fierce competitors in the cloud. Hence, a deepening of this collaboration looks increasingly unlikely as this move puts Amazon against Microsoft in a new area in addition to the cloud. Although Amazon appears to be getting the better of Microsoft, we still cannot stomach the valuation leaving me with a strong preference for Microsoft’s shares.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

30 November 2017

Uber – Annus horriblis

Even at $54bn, no shortage of sellers

While attention is focused on SoftBank’s moves to take a 13-15% stake in Uber, the deterioration of Uber’s fundamentals is a warning that its dominant position may already be slipping. Q3 17A revenues were $2.01bn up 21% compared to $1.66bn in Q2 17. However, net losses grew faster with Q3 17A net losses at $1.46bn, up 38% from the $1.06bn it lost in Q2 17A. This represents a deterioration in net margins to a loss of 73% from a loss of 64% in Q2 17A.

Given the year that Uber is having it is possible that the losses have been increased by non-operational items such as compensation payments and restructuring.  However, these headline figures come from an investor communication which typically will exclude costs and benefits that come from non-operational sources. Hence, we suspect that the 870bp decline in margins is operational in nature and represents a deterioration in the company’s underlying performance. This should be of huge concern because if its home market is going to descend into a bloodbath of cutthroat competition, then Uber is going to be raising a lot more money and most likely at much lower valuations.

We are quite surprised to see such a deterioration as despite Lyft’s recent increases in share, Uber is still hugely dominant in its home market, USA.  So far in 2017 Uber’s lack of focus has led to Lyft being able to confidently expect to improve its market share to 33% from 20% at the beginning of the year. This leaves Uber on 66% which based on my rule of thumb for network based businesses, is still enough to eventually win the market, but its margin for error has been substantially reduced. This rule of thumb states that a company that relies on the network must have at least 60% market share or be at least double the size of its nearest rivals to begin really making profit.

Coming into 2017, Uber had a 20% cushion before Lyft could really start causing it some problems, but this cushion has now been reduced to just 6%. Uber’s figures are implying that Lyft is beginning to impact Uber’s ability to make money which is a real problem. Google is now Lyft’s biggest backer as it represents the best way for it to get its self-driving technology (Waymo) to market.  As of Q3 17, Google has $100bn of cash on its balance sheet giving Lyft potentially much deeper pockets than Uber. This combined with how much it has closed the gap on Uber over the last 9 months, means that Lyft is now a real threat.

This is a much more important issue because if Lyft is able to impact Uber’s financials, it means that its hallowed status of market dominance has already been lost despite my rule of thumb. This is critical because Uber’s $70bn valuation compared to Lyft on $11bn is based on its dominance of the market and the unassailability of its network effect.  Consequently, the real valuation of Uber may be far lower than even the $54bn that SoftBank is offering existing shareholders to purchase some of their stock. These investors include Benchmark and Menlo Ventures who may have already have arrived at this view and concluded that $54bn is a great exit price. Hence, we still expect there to be no shortage of sellers at this lower valuation.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

28 November 2017

E-commerce – Look East.

In mobile, China is more developed than USA

Comparing China’s Singles Day against Brown Thursday, Black Friday and Cyber Monday in USA reveals just how much more advanced the development of the mobile online consumer economy is in China. The first figures for Brown Thursday Black Friday are coming in with Adobe estimating that $7.90bn (Gross Merchandise Value, (GMV)) was spent online with another $6.6bn expected to come on Cyber Monday. Of the $7.90bn, 37% of the revenue was produced by a mobile device of which 70% was transacted via a smartphone (26% total turnover).

While these figures are the best ever for the USA in terms of total turnover and smartphone share, they pale into insignificance when compared to Singles Day in China. Between them, Alibaba and JD.com make up 87.2% of all B2C e-commerce in China and on Singles Day they racked up $44.7bn in GMV. In just one day Chinese e-commerce turned over 5.7x in GMV than the two US days put together. If one includes the expectations for Cyber Monday, then the total US holiday shopping period is dwarfed by a factor of 3 to 1. Furthermore, 90% of all of Alibaba’s GMV was transacted on a mobile device and AliPay handled a total of 1.5bn transactions. It is clear that a big discrepancy here is that Singles Day a recently created, online-only event whereas Black Friday has been going since 1952 and remains mostly an offline event that’s is slowly migrating to online.

However, the scale of the difference between the two clearly demonstrates that when it comes to online transactions and mobile, China is far more developed than USA or other developed markets. Reasons for this may be that the offline experience in China is very poor. This is the case for many sectors but particularly in retail. Chinese offline retail is a fragmented and frustrating experience where decent service and information with regards to inventory, product lines and so on is routinely not available. When an online offering appears where this information is clear and one is able to easily purchase goods and know when they will be delivered, shoppers quickly adapt. Hence, Chinese consumers have very quickly adapted to online shopping as the experience and ease of use is far superior to offline.

Another reason is that China is a mobile first market. Cellular connectivity in China has better penetration of broadband connections, higher throughput and lower latency than fixed Internet. Consequently, mobile is the first choice for Chinese users as it almost always offers a better user experience. This is also why we have begun to see reversal of the direction of innovation in mobile services. Historically, Chinese companies have copied ideas pioneered in Developed Markets, but this has changed meaningfully. For example, many of the innovations that are being put into instant messaging platforms by Facebook, Snapchat, Apple and so on are already available in WeChat, LINE, Kakao-Talk etc. This is a trend we expect to continue going forward.

China remains dominated by the BATmen of whom we have preferred Tencent for the last 15 months. However, given its rally and its apparent slowness to monetise its ecosystem fully, we are beginning about switching into Alibaba.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

27 November 2017

Uber vs. Lyft – Blood in the water

This is Lyft’s best chance to catch Uber

With yet another skeleton emerging to hinder Uber, Lyft is increasing its recent fund raising by $500m as it has realised that now is its best chance to reel in Uber. Lyft has increased its recent $1bn round that was led by Google and CapitalG by another $500m bringing the total post-money valuation to $11.5bn. The extra money will be invested in passenger and driver products which basically means reducing the fares and increasing driver take-home in a bid to gain market share. 2017 has been a great year for Lyft but only because Uber has pretty much had the worst year imaginable.

Constant turmoil, management turnover, bad press, unhappy drivers and a series of scandals has led to the company focusing on anything but its core business in 2017. This has taken another downward lurch with the disclosure that it suffered a data breach on 57m users and failed to make the users aware that their data had been compromised. This is exactly the kind of bad press that Lyft can capitalise on when it comes to tempting existing Uber users to consider trying Lyft. So far in 2017 this has been very successful as Uber’s lack of focus has led to Lyft being able to confidently expect to improve its market share to 33% from 20% at the beginning of the year. This leaves Uber on 66% which based on my rule of thumb for network based businesses, is still enough to eventually win the market, but its margin for error has been substantially reduced.

This rule of thumb states that a company that relies on the network must have at least 60% market share or be at least double the size of its nearest rivals to begin really making profit. Coming into 2017, Uber had a 20% cushion before Lyft could really start causing it some problems, but this cushion has now been reduced to just 6%. Furthermore, with Google is now backing Lyft as the best way for it to get its self-driving technology (Waymo) to market, this gives Lyft much deeper pockets than it had previously. This combined with how much it has closed the gap on Uber over the last 9 months, means that Lyft is now a real threat. If Lyft can take another 6% or more of market share from Uber, Uber will have lost its hallowed status and as a result we would expect its financial performance to deteriorate materially.

All of this plays in Lyft’s favour as Uber’s reputation is now in such a bad state that it has to tread very delicately wherever it goes. This means that the aggressive expansionism that gave Uber its dominant share is no longer possible handing all the initiative to Lyft. We have been very negative on Lyft to date as its position looked hopeless but with Uber constantly shooting itself in the foot has given it a fighting chance. There is no way we can justify a $70bn for Uber given this outlook, and if Softbank is offering this to shareholders to build its stake,  this represents a great opportunity to exit.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

24 November 2017

Apple - No Nirvana

Vrvana unlikely to accelerate Apple’s AR

Apple’s acquisition of Vrvana is the best sign yet that it is intending to get involved in hardware for augmented and virtual reality, but Vrvana is extremely unlikely to be able to accelerate its time to market. Vrvana is a start-up based in Canada that launched a headset called the Totem which received good reviews but never shipped. We suspect that the device never shipped because the company could get its headset to a high-enough level of quality and reliability to make it in the marketplace.

Its Kickstarter campaign was pulled as the company realised that its product would never meet the funding goals. Furthermore, the Totem headset itself looks like a lot like a DIY project and is nothing that we would ever expect Apple to ship.  Hence, Apple’s interest in Vrvana is more about the technology that Vrvana has used to create the Totem. The Vrvana Totem is capable of both AR and VR in the same unit. It is able to do this by superimposing the real word onto the virtual which is the opposite of how almost everyone else does it. Instead of having transparent lenses through which the real world can be viewed, it uses cameras to record the real world and superimpose them onto the virtual. There is one camera for each eye such that depth perception of the real world can be maintained through standard stereopsis techniques. The real-world images are being digitised before being mixed in with virtual images, the virtual images can be completely opaque. In every other AR system, the virtual images are always somewhat translucent which reduces their ability to appear real as one can always see the real world behind them. Consequently, using this set-up there is scope to mix the virtual and the real world more realistically.

This is what has interested Apple as the hardware itself is clunky, cumbersome and unattractive to look at. The issue with implementing AR this way around, is that the user is still completely closing himself off from the real world and the head unit used is likely to be far more obstructive than a simple pair of glasses. Consequently, this acquisition as highly speculative on Apple’s part with a high probability that this technique for AR ends up being discarded. Given the difficulties being faced by everyone in the AR field, we do not see Apple being ahead of the field nor will this acquisition accelerate its time to market.

The net result is that while Apple is right to explore the possibilities of AR, there is no concrete intention to launch a unit. We see this activity much like the vehicle or the television which were experiments that failed to stand up to the scrutiny of market reality. Consumer AR is likely to remain a prisoner on the smartphone for the foreseeable future where no one looks capable of effecting a prison break any time soon.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

22 November 2017

Sonos – Sounds of sameness pt. III.

Sonos has finally enabled Alexa voice control and Spotify support in its speaker systems thereby ensuring that it will now be competing purely on the quality of its hardware. The Sonos One is Sonos’ first voice-activated speaker which has received rave reviews for its sound quality, but very little else. This is because this device uses Amazon’s Alexa to control its functions and is adding support for streaming services like Spotify and Tidal with increasing regularity. While this is exactly what is required to sell speakers in this day and age, it is confirmation that Sonos has completely lost its mojo.

Sonos was very early into digital music streaming around the house and developed a suite of software that made multiroom music possible. While this was a novelty, Sonos achieved differentiation and was able to charge a premium price for its high-quality audio products with this functionality. Unfortunately, Sonos has squandered the lead that it had and instead of using its lead to maintain its differentiation, it focused on trying to lock users into its products. It tried to do this by only allowing users to access popular services such as Spotify, Amazon and so on via its own app. The idea was to create a compelling user experience such that users would choose a Sonos even if something of equivalent quality was available at the same price point. Unfortunately, this is where it has all come unstuck as Sonos’ ecosystem delivers a frustrating, buggy and substandard user experience that users would not use if they had a choice.
By enabling both Spotify Connect and Amazon Echo, Sonos has removed the requirement for users to use its software which is a sign that it is giving up on trying to create user preference around an ecosystem. Because Amazon Echo and Spotify Connect are keen to work with any speaker on the market, Sonos’ differentiation now becomes: audio quality and design. Multiroom functionality is now table stakes in the home speaker game.
Hence, Sonos’ only chance is to either invest in cool new hardware features and stay ahead of its competition to maintain its price premium or go for volume and gain scale advantages by significantly outselling its rivals. Both of these will be extremely difficult to achieve as much bigger and stronger rivals are all investing in producing great audio quality in a small package and the market is rapidly fragmenting given the low barriers to entry.
Given Sonos’ current position, both of these options would have required a bold strategic move from Sonos that would probably have had the most chance of success if it had appointed an outsider as CEO rather than its COO. Sonos now has nothing to differentiate it from Apple HomePod, Google Home Max and so on meaning that its only weapon will become price. This is big problem because its larger and more powerful rivals are more than capable of subsidising these products in order to push their ecosystems deeper into the home. The net result of this is likely to be a weakening of Sonos’ financial position to the point where one of the larger players is able to buy it at a discounted valuation. We see Samsung, Apple, Sony, Tencent and Amazon as potential acquirers.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

20 November 2017

Alibaba – Offline grab.

Alibaba is very different to Amazon

Alibaba’s investment in Sun Art has nothing to do with Amazon’s strategy with Whole Foods, and everything to do with the woeful state of the offline transaction experience in China. Alibaba intends to invest $2.9bn in Sun Art, a hypermarket operator which has 446 stores in 224 cities across China and turnover of around $16bn. Alibaba will acquire a 36.2% stake in the company which to date has operated as a j.v. between French retailer Auchan and Taiwanese conglomerate Ruentex Group.

Offline retail in China is still massive at $4.5tn despite the rapid expansion of e-commerce and is a great example of why online and mobile have been so successful in the Chinese market. Chinese offline retail is a fragmented and frustrating experience where decent service and information with regards to inventory, product lines and so on is routinely not available. Consequently, when an online offering appears where this information is clear and one is able to easily purchase goods and know when they will be delivered, shoppers quickly adapt. It is the terrible offline experience with regards to almost everything that has allowed so many other goods, services and activities in China to rapidly migrate from offline to mobile. Alibaba’s strategy with Sun Art is all about turning it into a high quality and efficient retailer using the technologies and logistics expertise that it has gained with the development of its e-commerce business.

This is very different to Amazon and Whole Foods as Whole Foods already provides a pretty good and reliable retail experience with good logistics. Amazon’s interest in Whole Foods is about ensuring that there will be enough volume in perishable items to give it the scale to push more and more groceries through its site. In effect, Amazon has acquired a huge customer for that business to give it critical mass so it can economically expand groceries to its online customer base.

In contrast, Alibaba is doing something very different in making a play to take a big piece of the Chinese offline market. If Alibaba can make Sun Art and its other partners like In Time and Lianhua Supermarket superior to then these stores should begin to gain market share over their rivals. Given that Chinese retail is such a vast market, steady market share gains here has the scope to keep growth going at Alibaba (albeit at lower margins) once e-commerce begins to slow down. It also offers Alibaba the opportunity to move other sectors of retail online once it has licked them into shape. Hence, this move makes complete sense for Alibaba as there is a very clear opportunity for it in China which is completely different to that being followed by Amazon.

Alibaba is beginning to understand the importance and opportunity presented by the data its digital assets generate. While it is behind Tencent in Digital Life coverage, we are increasingly of the opinion that it is moving more quickly to understand the opportunity offered by the digital ecosystem. Hence, when Tencent runs out of steam, we will be considering this one very carefully as a possible switch.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

17 November 2017

Google vs. Facebook – AI dividend.

Google’s AI already pays dividends

Both Google and Facebook have a fake news problem but Google’s leadership in AI means that it is likely to have a better solution and will not have to materially impact the financial performance of the company to fix it.

Over the last 2 years, Google, Facebook, Twitter and so on have become far more important when it comes to delivering current events to users. This is particularly relevant when certain events occur that result in regular citizens present at these events uploading videos and commentary long before the more established media outlets can arrive on the scene.

As a result, important information often appears on Google, Facebook and Twitter first, meaning that the accuracy and veracity of this information is of paramount importance. Unfortunately, during these sorts of events, there is often a scarcity of information available making it the easiest time to successfully propagate fake news.

This is the problem with which both Facebook and Google are wrestling, but from looking at how both are dealing with it I think there is a huge gap between these two players.

To combat this problem, Facebook has announced that the total number of employees working on safety and security will be doubled from 10,000 to 20,000. Given that the total number of employees at the end of June 2017 was 20,658, this implies that 50% – 60% of all Facebook employees will be working in non-revenue producing positions. This will mean that costs will meaningfully outstrip revenues leading to a “significant” decline in profitability. These humans are being shipped in to deal with the problem because Facebook’s AI is not even close to being good enough to deal with it. Furthermore, this is a problem that humans cannot really solve given the velocity that is required.

To be fair to Facebook, Google’s data tends to be somewhat more structured than Facebook’s making it easier to analyse but this does not come close to explaining the difference in AI ability. Although Google remains reluctant to discuss the methods it is using to combat this problem, this is something that it has been dealing with for many years and there has been no sudden increase in current for forecasted headcount. There has also been no sudden decline in gross margins (current or forecasted) which would indicate that Google had taken on contractors to help fix the problem. While Google does use fact checking services to ascertain the veracity of some of the content that appears in its searches, almost all of its efforts are going into closing the loopholes in its algorithms that allow fake news to surface. This is why there is no financial impact on Google from this problem compared to Facebook.

Furthermore, using humans to combat fake news will end in failure. This is because it takes the human system around 2-3 days to reliably label an article or item as fake by which time is has trended and already been seen by millions of users. Consequently, having tens of thousands of humans scouring Facebook for fake news will not actually solve the problem.

Hence, this will result in $1bn+ of shareholders money being wasted in every year that humans are being used. This highlights the gravity of the AI problem that Facebook is trying to deal with and think it is one that Google is much closer to solving. Hence, Google being able to far more effectively manage this problem and at a fraction of the cost. From a shareholder value perspective, perhaps it is time to consider switching from Facebook to Google.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

16 November 2017

Android – Downward slope.

Fragmentation getting worse not better

Fragmentation in Android comes in two forms: Firstly, vertical fragmentation, which refers to the number of older versions of software that are still active and is exacerbated by a failure to update existing devices to the latest version. Secondly, horizontal fragmentation, which refers to changes made to Android by different device makers to bring their products to market. This results in a differing and inconsistent levels of performance from one device to another, despite running exactly the same version of software. Both vertical and horizontal fragmentation have a substantial and deleterious impact on the user experience and in our opinion are the main reason why the user experience on Android continues to meaningfully lag that on iOS.

Analysis by programmer Dan Luu is the clearest indication yet that instead of getting better, it appears to be getting worse. We had already partially noticed this when we calculated that at the rate at which Android 8.0 is being adopted, it will take 5 years to fully penetrate Google’s own user base compared to 4 years for other versions. Dan Luu’s analysis is much more granular and his chart clearly shows that for the latest version (far right-hand side), the update trajectory is meaningfully slower than for all of the previous versions. Previous versions have seen a much more rapid update pattern leaving me to conclude that either the number of devices being updated has suddenly declined or that manufacturers have started making new devices using old software.

Either way, the effect will be the same which is more devices running older software meaning that Google innovations that require a change in the OS to function will take at least 5 years to make it into the hands of all its users. This will allow iOS to continue comfortably outperforming Google Android on the RFM Laws of Robotics that test the user experience leaving this as major point of differentiation for Apple.

Furthermore, it will also ensure that Google continues to underperform its revenue generation potential on Android devices leading to lower revenues and profits. The more time goes by and the worse this problem becomes, the more we think that the only solution is for Google to take Android fully proprietary and put to bed the fragmentation issue once and for all. This is how Google could begin to see significant revenue upside from its own Google Android devices as well as close the gap to Apple. Its own efforts in hardware are unlikely to have nearly the same impact simply because its volumes are so small. We continue think that Google’s shares remain pretty fairly valued and prefer instead Tencent, Microsoft and Baidu.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

16 November 2017

Apple – Tick in the box.

Hacking of Face ID proves its security

A Vietnamese cyber security firm and Android phone maker, Bkav Corp, has managed to reliably bypass Face ID (see here) by creating a 3D mask of the user’s face with special attention being paid to the eyes, nose and mouth. However, it is pretty clear that a huge amount of work went into the creation of this mask.

Firstly, it was designed using expert cyber security knowledge and an intricate understanding of how Face ID works. Bkav first demonstrated a bypass of facial recognition on laptops in 2008 and has been a player in the field ever since. Secondly, 3D printing, 2D printing and hand-made artistry was used to create the mask indicating just how intricate the process was. Thirdly, each mask costs $150 to produce. Finally, it took 9 days to crack (even with at least 10 years’ experience) and we suspect Bkav was working on this flat out.

The net result is that Bkav continues to advocate for the fingerprint being the best method of authentication for an electronic device. However, we think that the intricacy and cost of this hack, combined with the fact that a detailed 3D scan of the user’s face is required, is actually an endorsement of Face ID as a verification system.

Taking this with surveys that suggest that 60% of users prefer the system over fingerprint (9to5 Mac) and the fact that there few reported issues with the reliability and speed of the system leads us to think that Apple has successfully ticked this box. Nevertheless, fast and reliable Face ID is clearly quite difficult and expensive to achieve (Samsung’s is awful), which leads us to think that Apple has set a standard for high end devices going forward.

We think that this will trickle down through the tiers with time, but it looks like fingerprint sensors may have a limited life span. Furthermore, Apple now has a clear point of hardware differentiation over its competitors that is likely to last for a generation or two.

It is worth noting that, in the ecosystem, Apple is still miles ahead primarily due to Google’s inability to deal with the endemic fragmentation, security and updating issues that continue to hamper the Android user experience. Hence, we remain unconcerned for Apple’s iPhone gross margins for the next 12 to 18 months. That being said, we think the shares continue to price in a larger iPhone X driven cycle of replacement than we see as likely. This, combined with excellent price appreciation so far this year, leaves us indifferent to the shares.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

9 November 2017 · 3 min read

Tencent takes a 12% stake in Snap

Tencent is embarking on a circumnavigation of the Digital Life pie in order to build an ecosystem to challenge the established Google, Apple, Amazon, Facebook dominance of consumer digital services

Following the most difficult set of results after its IPO, Snap has conveniently announced that Tencent has taken a 12% stake in the company. This has awoken take-over speculation that we thought would not really emerge before the shares dropped below $10 and should provide a badly needed boost to sentiment.

In its 10Q Snap stated that it had been notified by Tencent that it has purchased 145.8m shares representing a holding of 12% in Snap Inc. If this had been purchased purely through the exchange it would have consumed 25% of the free float which would have been noticed triggering a rally and speculation. Consequently, the majority of this stake was accumulated by approaching existing holders directly whom were only too happy to sell.

We do not think that this transaction has anything to do with Tencent’s China business but instead is more about Tencent looking at ways of spreading its wings overseas. Digital Life services in developed markets do not work well in China (mostly because they are blocked) while Chinese Digital Life services do not work well in developed markets as they do not fit culturally and also are predominantly in Chinese. Consequently, the BATmen have had to seek other ways to develop overseas other than just spreading their Chinese services into developed markets.

Alibaba is approaching this using the Trojan horse of Alipay, while Tencent is showing signs of assembling a range of assets that would give it good coverage of Digital Life in developed markets. This process began with the acquisition of Supercell in June 2016, continued with an attempt on Spotify that failed and now it seems to be latching onto Snapchat. Tencent is the global market leader when it comes to Digital Life coverage with 77% of the Chinese pie covered and 30% of the developed market pie covered with its position in Supercell.

Adding Snapchat would take this coverage to 44% ahead of both Google and Apple (who have 40% each). However, it is one thing to have good Digital Life coverage and quite another to create a vibrant ecosystem that one can effectively monetise. The vast majority of Tencent’s revenue comes from selling content and games rather than from monetising its community.

It increasingly looks as if Tencent is embarking on a circumnavigation of the Digital Life pie in order to build an ecosystem to challenge the established Google, Apple, Amazon, Facebook dominance of consumer digital services. Consequently, we expect Tencent to actively seek investments or acquisitions in Media Consumption, Search, Social Networking and so on in order to build its coverage. This is likely to prove to be expensive and in my opinion the real challenge for Tencent lies ahead. This will be to assemble and integrate these assets into a vibrant and consistent community which is something is has yet to do with the majority of its assets in China.

Tencent is the strongest of all the Chinese ecosystems and the share price still does not reflect all of the potential upside. Hence, there is still not much very downside in Tencent if it fails to integrate its assets. However, should it do so, there is plenty of further upside from here. Tencent, along with Baidu and Microsoft remain our top picks.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

8 November 2017

Facebook vs. Snap - Own Goal Pt. II

An unaffordable outage

Snap Inc’s Snapchat service suffered a 4 hour worldwide outage that enraged its users, greatly increasing the risk of defection to Facebook’s more reliable and much larger stories service. Snap Inc. is already having a tough time competing against Instagram Stories and these sorts of events are simply unaffordable if Snap Inc. is to have a chance of succeeding and remaining independent.

Snapchat currently has around 173m DaU but despite launching just 14 months ago, Instagram Stories now has over 300m. This is doubly troubling as not only is Stories now twice the size of Snapchat, it is growing much more quickly. This strongly implies that users who like the type of service pioneered by Snapchat can now access a much bigger network without having to leave Facebook’s environment. This has proved to be very successful as evidenced by the fact that Instagram Stories is growing very quickly while Snapchat has stagnated from the day it went public.

Many users, who might have otherwise signed up with Snapchat, have opted to stay with Instagram thereby depriving Snap Inc. of its badly needed growth. This is why an outage is something that Snap Inc cannot afford as it meaningfully increases the risk that, on top of not gaining new users, it may begin to lose its those that it already has. Furthermore, Data from Captiv8, the audience tracking service, indicates that influencers are leaving Snap and are finding their way to Instagram. During Q2 17, Snap saw a 20% decline in influencers while Instagram saw an 11% jump. Snap Inc. is already struggling with the loss of key influencers who are defecting to Instagram as Instagram is making it very easy for them to get set up and critically, make money. In many ways influencers are a bit like developers which in order to get going, need lots of love and support.

Facebook and Instagram have understood this and acted upon it while Snap’s management does not seem to care that much. Snap badly needs to address this situation as influencers are key for marketing to its key user base. Take this in the context of enraging users with a service outage and the stage is set for very little progress to be made in terms of getting the user base growing again.  Consequently, we think that Q3 17 and Q4 17 will continue to see the user numbers and the engagement disappoint leading to more pressure on the share price.

While Twitter is also stagnating, it is in a much better strategic position as it remains unopposed in its space. Snap by contrast is under colossal pressure from Facebook which could lead to the shares dipping well below my fair value of $12.40 a share. If they were to hit $10 or below, we could see acquirers coming out of the woodwork. Until then, there is no reason whatsoever to get involved.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

7 November 2017

Razer phone - In character

For hardcore fans only

Razer has stuck to what it knows in its in launching first smartphone, but its focus on gamers means that the device looks very dated against competition in its price tier (Galaxy s8, Mate 10 Pro, iPhone 8 etc).
The Razer phone sports a very average looking screen with large top and bottom bezels but these make sense in the gaming context. The most annoying thing about playing games on smartphones that are all screen, is that there is nowhere to rest one’s thumbs.

The large bezels also provide the real estate to include high specification speakers and Razer is also pushing audio as a differentiator for this product. Razer has provided for this at the expense of aesthetics but combined with a 120hx refresh rate on the display and a snapdragon 835 and a whopping 8GB of RAM, it is safe to say that this will provide arguably the best overall gaming experience. True to its roots it also allows gamers to tweak the performance of the device to optimise battery life against performance with the Razer app that comes preinstalled.

The Razer phone is effectively a tweaked Nextbit Robin which was the lead product of the small phone maker that Razer acquired in January. This makes sense as it would have been almost impossible to come up with a new design from scratch in such a short time period. Unfortunately, in order to benefit from the 120hz refresh rate, games companies need to include support for it in their apps meaning that the majority of Android games will not be able to make use of this key feature.

However, it has announced partnerships with Tencent, Square Enix, Namco and several others meaning that some high-end games will be able to work optimally with the device. Razer has a similar problem to the one that caused Microsoft no end of grief which is that the average consumer will not understand its product and will only see an old looking device at a high price.  Consequently, this is an enthusiast device that will only be purchased by users that are already very familiar with Razer and most likely own its products.

That being said, we have estimated that the software that it offers on its PCs has between 5m and 10m active users, which probably makes up a big part of its core fan base. If 5-10% of these users buy the device, then this would represent shipments of 500,000 or revenues of around $280m. This would help support Razer’s lofty valuation of around 10x sales at IPO, but margins are likely to be very low, leaving us to believe that there will be a better time to consider this one.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

6 November 2017

Apple FQ4 - All things X

X hits the spot

Apple reported good results and guided strongly for FQ1 18 as it has managed to deal with some of the production problems with the iPhone X which will result in slightly better than expected shipments in FQ1 18. FQ4 17 revenues / EPS were $52.6bn / $2.07 compared to estimates of $50.7 / $1.87.

Slightly soft iPhone 8 demand has been offset by a 25% jump in Mac shipments and a 14% jump in iPad. Both of these products have clearly gained some share as the end markets for PCs and Tablets have remained quite soft. The big problem with the iPhone X has been the facial recognition system where suppliers have struggled to produce enough components to the specification demanded by Apple.

We suspect that the slight relaxation of the original security requirement has enabled more of the 3D sensors to meet the grade enabling the slightly better supply underpinning FQ1 18 guidance. As a result, guidance for FQ1 18 was slightly ahead of expectations with revenues / gross margins of $84bn – $87bn / 38.0% – 38.5% forecast compared to expectations of $84bn / 38.5%.

The traditional lines outside the stores that were completely absent when the iPhone 8 / 8+ became available, have formed for the availability of the iPhone X leading us to believe that the company is on track for a pretty good replacement cycle. However, we do not think that the iPhone X will offer a cycle nearly as big as the iPhone 6 and my concern is that this is what the market is looking for.

In expectation of this super cycle, the valuation of Apple as expanded materially leaving us concerned that much of these heady expectations has already been priced into the stock. Consequently, the valuation argument for Apple is not nearly as strong now as it was 12 months ago, leaving somewhat less inclined to hold the shares for the long-term. We continue to prefer Tencent which has some upside left given its global leadership in Digital Life coverage and Baidu which represents the cheapest way to invest in the trend of AI. Microsoft continues to be steady albeit much less exciting than the other two.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

1 November 2017

Razer - The public game

Razer, too early to go public

Razer wants to become the ecosystem for gamers but its progress in this area is at such an early stage that we think it has no business being a public company. This is because when a company is in transition, things rarely go to plan meaning that deviations from forecasts on results day are likely to be large resulting in wild swings in the share price. The fact that Razer is listing at $4.5bn, which is more than 10x the revenue that the company is likely to report for 2017, means that any slips or misses will be severely punished.

Razer is a PC Gaming hardware company that prides itself on providing PCs and peripherals that cater to exactly what gamers want. On the back of this PC enthusiast niche, it recorded sales in 2016 of $392m upon which it made a reasonable gross margin of 28%.  However, just $0.095m (0.2% of turnover) was from software and services which grew to $0.11m (0.6% of turnover) in H1 2017. This indicates that first and foremost, Razer is a hardware company whose best shot at monetising its ecosystem will be through premium device pricing.

Apple is the gold standard of hardware monetisation where its gross margins on the iPhone are comfortably over 40%. This means that Razer needs to use software and services to create a user experience that can only be had on Razer products driving increases in prices for Razer products over and above competition. This will be very difficult as virtually all of its products only run software and content created by third parties that is available elsewhere.

Furthermore, its ecosystem is almost non-existent today. At the heart of its fledgling ecosystem a is a software platform that launches, aggregates and compares prices of games as well as software that enables LED colour patterns. This software has 35m registered users but the fact that there are only 7.8m likes on Facebook, 2.9m Twitter followers, 1.8m Instagram followers and 1.2m followers on YouTube leads us to think that the active users are somewhere between 5 and 10m. In order to hit critical mass, an ecosystem needs to have 100m+ users indicating that Razer has a very long way to go. However, given that gaming is a specific niche within the consumer electronics industry, critical mass for Razer could be substantially lower. Twitch now has well over 100m active users and so if Razer was to achieve somewhere in the realm of 50m, that could be enough to begin ecosystem monetisation in earnest.

Razer is also planning to launch a gaming-optimised smartphone which does make some sense as gamers who play games on PCs do also play games (albeit different games) on smartphones and tablets. This has been tried multiple times in the past with no success but gaming does remain the one segment of the Digital Life pie where there is no dominant player in developed markets. As a result, if Razer can create a vibrant and engaged community of gamers on its mobile devices then it could begin to generate device preference which in turn will lead to increases in gross margin. Unfortunately, at a valuation of $4.5bn (around 10x revenues) a lot of this success (which is far from guaranteed) is already being priced into the shares. As a result, any slip (which is quite likely given the transition) is likely to be severely punished by the market meaning that there will probably be a much better time to consider being involved.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

31 October 2017

Facebook, fake news

“There is in fact a silver bullet but the real problem that Facebook has is that it has no idea how to make it”

There is a silver bullet to deal with the fake news issue, but the problem is that Facebook is not even close to being able to produce one and is having to rely on old, ineffective bullets instead. This problem has been around for a while but really came to light in the summer of 2016, following a move to automate the selection of trending stories on Facebook. Simply put, Facebook’s AI is incapable of working out which stories are fake and which are true which led to false stories being highlighted by Facebook as treading.
Facebook’s reaction to this problem has been to throw humans at the problem and a Bloomberg investigation has indicated that this is not working well at all. Facebook has outsourced fact checking to PolitiFact, Snopes, ABC News, factcheck.org and the Associated Press for the period of 12 months but this has been problematic. In order to be flagged as disputed on Facebook, two of the contracted organisations have to mark the story as false at which point the number of users seeing the story is cut by around 80%. This manual process takes about three days to complete in many cases, it takes much longer.
On Facebook this is effectively useless as many stories will have trended, been seen by millions of users and disappeared again long before the humans can mark the story as false. Consequently, the only way to solve this problem is to have AI that scans stories as they begin trending and can accurately weed out the fake ones. This is where Facebook comes unstuck as RFM research has found that when it comes to AI, Facebook’s position is very weak.
This is not because Facebook does not have good employees in this area but merely because it has not been working on it for long enough. We believe that currently, excellence in AI has very little to do with how many big brains one has on the bench but how long one has been crunching the data. This is where Facebook really suffers as it has only been working on AI for a couple of years whereas Google, Baidu and Yandex have all been crunching data for over 20 years.
To be fair, Facebook has shown some progress on image and video recognition but on the recognition and elimination of fake news, we have seen none whatsoever. As a result, we believe that Facebook’s contention that there is no silver bullet to deal with the fake news problem is incorrect. There is in fact a silver bullet but the real problem that Facebook has is that it has no idea how to make it. Until it figures this out, the fake news problem is here to stay.
This weakness in AI is not limited to fake news but shows up everywhere across Facebook’s services making it the biggest challenge that Facebook is facing. This problem has to be solved properly for Facebook to achieve its long-term potential as a fully-fledged ecosystem offering deep and intuitive services to 2bn+ users. It this basis that we can make a case for liking Facebook in the long-term, meaning that this has to be fixed at all costs.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

26 October 2017

Tokyo Motor Show

The star of the Tokyo Motor Show is an electric sports vehicle designed by Toyota which has at its heart an assistant which neither Honda nor any other automaker has any chance of ever creating themselves.

The star of the Tokyo Motor Show is an electric sports vehicle designed by Toyota which has at its heart an assistant which neither Honda nor any other automaker has any chance of ever creating themselves. The best hope is for automakers to license or buy an assistant from elsewhere meaning that it is unlikely to provide them with an exclusive, differentiating product. The problem is that digital assistants require a high level of AI in order to function properly which is a skill that none of the automakers, not even Tesla, posses.

Speech recognition depends on several factors. High word accuracy has largely been achieved by most speech recognition systems, but it is one thing to know what the user said but quite another to know what he meant. Another factor is understanding what it is the user is asking for regardless of word order or manner of speech and the ability to understand context and circumstance. It is quite clear that not until machine understanding reaches this stage that voice can have any hope of providing a user interface that would obviate the use of a screen and be really useful in a vehicle. The two leaders in this space (Google Assistant and Amazon Alexa) both rely heavily on screens and both have products with screens either in the market or in development. This is particularly relevant in the automotive industry where for the foreseeable future, the driver will have to have both his hands and his eyes occupied elsewhere. Furthermore, it is clear that all of the user interfaces designed by the car makers, Apple and Google are not appropriate for use in the vehicle.
This is a main reason why users still predominantly use their smartphones for digital services in the vehicle meaning that the best infotainment unit is still the one in the driver’s pocket, which represents a very serious risk for the car makers long-term. This is because all of the value-added services that they are hoping to provide are likely to be delivered via embedded systems in the infotainment unit. Consequently, unless the vehicle’s embedded infotainment unit can compete effectively with the smartphone, there is a real risk that all of their digital aspirations will come to naught. In this case, the net result is likely to be the big ecosystems taking over the digital experience in the automobile causing the automakers to become little more than handsets on wheels.
This is a bleak outlook because we think that the automakers badly need revenue from digital services to help offset the weakness in their traditional business likely to be caused by the migration to electric vehicles. Failure is not an option for those that wish to survive.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

25 October 2017

Essential Products is clearly struggling with its Essential Phone which will lead to it focusing on

Essential Products is clearly struggling with its Essential Phone which we think will probably lead to it ending up focusing on the smart home only. Essential Products Inc. has used the only competitive weapon it ever really had and has cut the price of its flagship Essential smartphone by 29% from $699 to $499. Those that have already purchased the device will get a $200 credit towards purchasing other devices within the Essential ecosystem such as the 360 camera. The issue with this is it will really annoy fans of the device who paid full price and it is also an admission that there is nothing particularly special about this device leaving Essential Products in the same boat as everyone else in terms of competing on price. This is a real climb down for the company because competing directly with the Chinese and LG directly on price, it means that the user experience and ecosystem that it spent so much time creating is getting no traction with users. This fits exactly with our previous observation that Essential Products has created a great Google phone and nothing more.

Essential’s strategy is to create an ecosystem of products and services around its smartphone that reach into smartphone peripherals and the smart home. In the smart home, Essential has a good grasp of the real problems and has designed a product to address these issues but digital ecosystems are still completely defined by the experience on the smartphone.

Essential aims to differentiate in hardware, AI and the cross-device compatibility and consequently to get its innovations in the hands of users, it thinks that it needs a smartphone. The aim with the price cut is obviously to drive volume and user numbers but we suspect that this will put real pressure on its gross margins meaning that the $300m recently raised by the company will erode much more quickly. Furthermore, this action will almost certainly result in a hit to the company’s credibility as it makes much of the message it communicated at the time of launch look hollow. We continue to think that the company has no differentiation in smartphones but its strategy in the smart home looks interesting.

Consequently, we can see the smartphone being dropped with all the remaining focus and resources being placed on creating a position in the smart home. This will be easier and said than done as it is up against two companies that sell good products at cheap prices and have both the means and the will to lose money for a sustained period to build the market position they are looking for.  Against this, Essential Products has little chance but its hope lies in its understanding of the smart home and moving to address it ways that its opponents are currently failing to do. It has to move fast as both Amazon and Google are showing signs of realizing what it is they are missing in the smart home.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

23 October 2017

Microsoft, Huawei & ZTE -Hardware heaven?

3 big leaps but potentially with fatal flaws

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

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

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

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

18 October 2017

Broadcast TV - Sword of Damocles pt. III

OTA broadcast given a second chance

While Netflix and Amazon continue to make inroads into the cable TV subscribing population, the old dinosaur of over-the-air (OTA) broadcast seems to be winning a second lease of life.
Over the last 4 years it has not been a good outlook for broadcast (OTA and cable) as we have viewed the convenience and lower cost of on-demand viewing as a much better proposition for users. However, while this prediction has been largely accurate, what we failed to take into account was the fact the OTA is free (ad supported) which is largely what lies behind its renaissance. A standard Cable TV subscription in 2016 cost on average $103.10 per month for which a large number of channels come as a prepaid package. Most users watch only a few of those channels meaning that it if they could subscribe to those channels individually, they would be in a position to save a lot of money. This is now becoming a reality as some of the most prized content now belongs to the streaming companies as well as other content creators making their content available as a subscription through the Internet.

The most obvious response has been the well documented and accelerating cord cutting by US households unless the cable TV industry takes immediate and drastic action. The other effect appears to have been a substantial recovery in the number of households making use of OTA rather than cable. According to a Nielsen study commissioned by Ion Media, OTA only households has grown by 41% over the last five years to 15.8m households although this may have slowed significantly since 2015.  Furthermore, this is not limited to older generations as the median age of households using OTA and not cable is lower at 34.5 years than the total households using TV at 39.6 years. Although the total number of households switching back to OTA-only may have slowed, there has been real growth in households that also have a fast broadband connection.

This leads us to believe that users (young and old) are increasingly switching off cable and replacing it with a combination of premium streaming services and OTA TV. This allows the user to have access to a wide range of channels, almost all the content he was watching on cable at a much lower price. Consequently, while commentators are cautious on the outlook for TV advertising revenues in 2018 and beyond, they could easily witness a recovery having been stalled for some time.

While this gives OTA a reprieve, it needs to act to prevent itself from becoming obsolete in the long-term. The obvious move is to make the entire selection of channels available on a single, free, ad-supported streaming service. That way the valuable spectrum can be re-farmed for a more economically productive use and OTA can ensure that it has a place in the future of the media industry. If it is really sharp, OTA will also seek ways to make its offering available in emerging markets which are highly price sensitive and willing to consume advertising in lieu of paying a subscription. We still think cable TV is going the way of the Dodo but OTA looks like it has been given some time to reinvent itself.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

17 October 2017

OnePLus - Learning curve

OnePlus’ slip serves as a warning

BBK Electronics is fortunate that OnePlus is one of its marginal brands as a gaffe of this size at Oppo or Vivo could have done real damage. OnePlus is a subsidiary of Oppo which in turn is owned by BBK Electronics (like Vivo) and has its own favour of Android (GMS compliant) called OxygenOS. Unfortunately, OnePlus decided to include code in OxygenOS that captured and uploaded: IMEI, serial number, MAC addresses, IMSI and WiFi network data in addition to which apps were being opened and what the user was doing in those apps. This data was being uploaded and analysed by OnePlus without either the knowledge or consent of its users.

OnePlus claims that the data was only being used to improve the user experience but that has not earned the company a free pass. However, once the company had been rumbled it was reasonably quick to react explaining how users can turn off usage data collection but for the other data it stopped short of saying that it would cease collecting it.

We suspect the real problem here lies in the cultural difference between China and developed markets – in China, privacy is much less of an issue where almost all services collect and use data without the user’s permission. Critically, the users do not seem to mind. However, in developed markets, a flagrant disregard for the users’ privacy can sink a product or service. It is likely code used in China was simply translated into English and launched into developed markets without a second thought. This is not the first time that this has happened nor, will it be the last as smaller Chinese brands try and leave the home market.

Fortunately, it appears that this lapse has not also occurred at Oppo which ships a third of its volume overseas (10m units Q2 17) which would be at risk of losing a substantial part of its business as a result. OnePlus is too small for anyone to really notice or care but it serves as a warning to other companies. Being aware of the differences between China and the rest of the world may make the difference between success and failure.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

16 October 2017

Samsung Q3 17 - Spring clean

Now is the best time to clean house

Samsung’s chip business has driven yet another mighty set of results making it the perfect time to deal with all of governance issues that continue to plague the company. Q3 17 revenues and EBIT are expected to be KRW62.0tn / KRW14.5tn slightly ahead of estimates at KRW61.8tn / KRW13.4tn.While these results are not very far ahead of expectations, Samsung has generated 2.8x more EBIT than Intel is expected to have generated in the same period which will put Samsung’s chip business comfortably in the global No. 1 slot where it looks it is going to stay for some time.

Handsets have also had a good quarter driven by its well-received flagship products but the real star of the show remains semiconductors. Typically, an environment of limited supply and strong demand is ruined by over enthusiastic capacity additions but we see the semiconductor industry being a little bit more cautious these days. It is due to the prohibitive cost of building a cutting edge fab and the fact that worries regarding Moore’s Law grinding to halt are now firmly on the investment horizon. The big question mark remains China which has said that it wants to create its own semiconductor industry (not including Taiwan) and aggressive roll-outs there could cause yet another demand / supply imbalance.  Either way this will take some time meaning that Samsung’s chip business is likely to continue generating vast profits for at least 12-24 months.

Against this backdrop, the outlook for the shares remains pretty steady which makes it the perfect time to deal with the corporate governance issues that have been plaguing the company. This appears to have begun in earnest with the resignation of co-Vice Chairman Oh-hyun Kwon who has also been serving as CEO. With Jay Y Lee also likely to out of the picture for a few years, the way is open for new blood to take the helm of Samsung and clean-up these long-standing issues. This is becoming increasingly important as the long-term discount in Samsung’s valuation has evaporated over the last 18 months. This means that the murky way that the company is owned, controlled and managed needs to be changed into something much more transparent. Failure to do this effectively is likely to result in a big correction in the valuation as soon as the current business momentum hits a bump in the road.

We are hopeful that today’s resignation is just the first step in this direction and that much more is to follow in the next 12 months. While the company is firing on all cylinders, tolerance to the skeletons as they leave the closet will be at its highest. Samsung’s timing looks to be excellent.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

12 October 2017

Yandex - Homeless

Alice needs a hardware home

Yandex has jumped on the digital assistant bandwagon but with its history, it should be able to produce by far the best product for the Russian speaking market. However, it will be unable to serve the majority of use cases without hardware to carry it into the home or the vehicle. Yandex is the pre-eminent internet company is Russia with 65% market share in search and just seen off a challenge from Uber to also become the dominant provider of ride hailing. Most importantly of all, Yandex has been crunching data for over 20 years, which according to RFM research, is a major contributor to its RFM rating as No. 3 in AI behind Google and Baidu. Consequently, a digital assistant is an obvious product to launch and is one that has a much better chance of succeeding in Russia than any of the others even if they are taught to speak Russian.

The assistant is called Alice and is the result of putting together a series of AI projects that the company has been working on for some time.These include voice search, weather, news, maps and so on.
One key feature is speech recognition. Yandex claims that the assistant demonstrates near-human levels of accuracy when it comes to understanding speech. This is no great feat in English anymore but in Russian, this is likely to put Yandex meaningfully in front.

Alice is also able to process context. Alice has some short-term memory in that it remembers what the previous question was and is able to answer a follow-on question in the context of the first. This is quite a difficult AI problem to solve and the only other player that we have seen do a decent job of this is Hound from SoundHound. We have not seen this ability in Google Assistant, Amazon Echo, Microsoft Cortana or Apple Siri.

Alice is available in the Yandex Search app on iOS and Android as well as in beta on Windows PC but this is not where it is most needed. Usage of voice assistants predominantly occurs when the user’s hands are occupied such as in the car or in the kitchen. Consequently, to address this use case Alice needs to be resident in a home speaker of some description and, potentially, in a vehicle infotainment unit.

Yandex has stated that there will be further products forthcoming and we are pretty certain that a speaker (probably in conjunction with a known audio brand) will be shortly forthcoming. Given Yandex’s heritage in AI and its dominance in search, it looks unlikely that Amazon or Google will be able put up much of a challenge leaving the Russian speaking markets open for Yandex. It will have more difficulty if it wants to expand overseas but Russian is a big enough market for Yandex to fare pretty well just by staying at home.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

11 October 2017

Apple - Expectations gap

iPhone X unlikely to produce the needed super cycle.

Expectations for the iPhone X are at fever pitch and a super cycle is now required to prevent a sell-off in the shares. iPhone X is the first substantial revision to the design of the iPhone since the launch of the iPhone 6 and in many ways the circumstances are very similar. In 2014, the biggest complaint with regard to the iPhone was the size of the screen which was considered to be tiny compared to devices being produced by Samsung and the other Android handset makers. When Apple fixed this shortcoming with the iPhone 6/6+, there was a lot of pent up demand as users who could only have a large screen with Android were able to have the best of both worlds. This demand led to shipments growing (calendar quarters): Q4 14 46%YoY, Q1 15 40% YoY, Q2 15 35% YoY, Q3 15 22% YoY and Q4 15 0% YoY. This was followed by shipments declines in Q1-Q3 16 as the pent-up demand was exhausted and replacement rates normalised.

We do not think the iPhone X will stimulate a big enough uptick in replacement rates to meet the expectation that Apple will ship more than 255m+ units in its next fiscal year.
This is due to utility, as while the new screen is nice to look at and enables a big screen on a smaller device, it does not offer an increase in utility over the iPhone 7 similar to that of the iPhone 6 compared to the iPhone 5. Consequently, it will not create the same degree of desirability and therefore not trigger a similar degree of early replacements compared to the iPhone 6/6+. Secondly price; the device is meaningfully more expensive starting at $999 which may put some buyers off. Lastly, Law of large numbers.; the bigger Apple becomes, the more difficult it is to post the kind of growth that the valuation of the shares now demands.

The iPhone X will stimulate a replacement cycle but one that is smaller in magnitude compared to the iPhone 6. With an optimistic hat on, we can just about get comfortable with the following unit shipment growth (calendar quarters): Q4 17 15% YoY, Q1 18 8% YoY, Q2 18 22% YoY, Q3 18 10% YoY. This gives 245m units shipped during the next fiscal year which is below current expectations. The net result is that we think expectations for fiscal 2018 need to come back somewhat which is likely to trigger a sell -off in the shares bringing the valuation down somewhat. Hence, the time is right to take some money of the table and put it somewhere else.
Tencent, Baidu and Microsoft have less immediate downside in our opinion.”

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

10 October 2017

Microsoft - Blue Squares of Death

Google is the big winner from Windows Phone’s demise

Microsoft has admitted that Windows 10 on mobile is no longer a focus finally putting to bed any hope (however tiny) that Android handset makers had to escape from Google’s clutches. Their only hope now is that the EU forces Google to make its app store (Google Play) available without having to also install the rest of Google’s ecosystem and set it by default. Microsoft has already wound down the activities that it acquired from Nokia which, combined with barely a mention at developer events like BUILD, has made this fact obvious to everyone but this is the first time that Microsoft has openly admitted this fact. There will continue to be fixes and security patches for a while but no more than that.  Microsoft has blamed the lack of availability of apps and services from third parties as the main reason for the platform’s failure, but we have long believed that there was more to it than that.

The issue with developers is simply that they won’t develop for a platform with very few users as there is no way to make money. Without third party apps and services, it is difficult to get users to adopt a new platform resulting in a typical chicken and egg problem. Consequently, to kick start a platform, the platform owner needs to prime the pump in order to generate interest that will quickly feed off of itself. Microsoft has tried very hard to incentivise app developers by paying them money and even writing the apps for them but this was not enough. We have long believed that to succeed Microsoft needed to encourage both developers and users and it was in the encouraging of users where Microsoft really failed. We can refer to this as the Blue Squares of Death problem.

iOS has always been able to sell itself and Android was also a simple sell as it looked just like iOS except that it was cheaper. By contrast, Windows Phone was very different and as a result, Microsoft needed to explain to users why it was great and how they could live their digital lives with Microsoft. Furthermore, devices in the stores needed to be populated with data such that users would be able to clearly see how the Microsoft ecosystem would make their digital lives easy and fun. Without this data, the demonstration devices were simply screens with blue squares on them preventing anyone not in the know to understand the proposition. This needed to be done in conjunction with the efforts to get developers on board in order to give the ecosystem a fighting chance.

Microsoft’s mobile ecosystem has always scored reasonably well against the 8 Laws of Robotics and users who did use it generally reported a positive experience. It was the failure to educate the users that was the primary reason for the ecosystem’s failure. Marketing has never been Microsoft’s strong point and as a result it simply told users that the ecosystem existed and never explained to them why they should buy it. The net result was that the ecosystem never got enough momentum in order to keep the developers interested resulting in the long decline that we have witnessed.

The real loser here is not Microsoft, which is going from strength to strength in the enterprise, but the Android handset makers. If Windows had become a thriving alternative to Android and iOS then they would have had far more leverage over Google which could have resulted in much better economic terms as well as greater freedom. Unfortunately, with its failure, they are completely stuck giving Google a free reign to continue draining the Android industry of its profits. The one exception is Samsung whose profitability we have long believed comes from its huge volume advantage rather than any differentiation it is able to create on Android smartphones. Despite Microsoft’s failure in mobile, its strategy in the enterprise is going from strength to strength leaving us still comfortable with owning the shares.

 

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

9 October 2017

Amazon & Microsoft - One way street

Amazon gets the best of it for now.

Amazon looks to be the main beneficiary of the co-operation between Amazon and Microsoft which will see Alexa offer access to Cortana and vice-a-versa. Amazon and Microsoft are working on a co-operation where Windows 10 users will be able to get Cortana to open Alexa and perform its range of functions. Users of Amazon Echo products will also be able to ask Alexa to open Cortana and ask it to perform its various actions. The idea is that users get another easy conduit from which to access Alexa while Cortana is provided with a badly needed escape from the PC where it has been stuck since the collapse of Windows Phone. Cortana was originally designed to operate on a mobile device and consequently was taught how to work in a range of domains that are used on mobile.The problem is that most of these domains are irrelevant on a PC and as a result, Cortana is fairly useless where it is predominantly present today. This is exacerbated by the fact that Cortana has not really been taught how to work with the Office applications making the user experience for its main use case on a PC pretty poor. For example, asking Cortana to read my email results in a Bing search for “read my email” and it is quicker and easier to open documents in Office with a mouse than to ask Cortana to do it.

Microsoft’s artificial intelligence is actually better than Amazon’s as a result of the data it has been crunching via Bing but very little of this has found its way into Cortana. Consequently, Amazon has come up with a better product that is far more useful in the environment where it is present (speakers in kitchens and living rooms). Hence, we don’t see much of a use case for Alexa users to begin asking Cortana to do things but having access to Alexa via a PC could prove to be quite useful. This is particularly the case as Alexa is very good at shopping and controlling the smart home potentially making device control remotely from the office much easier. As a result, Amazon is the main beneficiary of this collaboration in the first instance.

However, if Microsoft’s AI continues to be better than Alexa’s then there is scope for a much deeper collaboration where Microsoft’s AI could be used to power some of Amazon’s services. The only problem here is that this could result in cross over between Microsoft and Amazon Web Services who are fierce competitors in the cloud. Hence, a deepening of this collaboration looks unlikely at the moment but may become a reality if Amazon’s AI continues to languish.
Although Amazon appears to have gotten the better of this deal, we still cannot stomach the valuation leaving us with a strong preference for Microsoft’s shares.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

6 October 2017

Google - Brain boxes

Clever devices are useless without volume

Behind the carefully orchestrated event was a series of strategies aimed at driving penetration of devices which to date have been very disappointing.
Google made up for slightly below par hardware by maximising its leadership in AI to provide best in class functionality as well as some unique features that no one else is likely to be able to copy for some considerable time. However, the key to badly needed volumes will be execution as Google completely bungled the open goal left by Samsung after its Note 7 disaster.

Google has updated the Pixel phones and has moved to OLED displays. In contrast to iPhone X, Google has opted to make use of the always on display feature that allows key information to be displayed when the screen is off with almost no impact on battery life. Why Apple declined to make use of this excellent feature on the iPhone X is a complete mystery. What really sets the Pixel 2 apart are the new features such as Google Lens which offers the best image recognition and the fact that Google uses AI to do with one camera while everyone else needs two. However, Google openly admitted that volumes of Pixel have been disappointing and its offer of a free Google Home Mini is clearly aimed at driving badly needed volumes of this device. Pricing remains punchy at $649 for the Pixel and $849 for the XL making the comparison to better looking Samsung s8 and iPhone 8 inevitable. We suspect price is going to be an issue for users considering this device.

Two new products were introduced for Google Home. The Google Home Mini ($49) which takes direct aim at the best-selling Amazon device (Echo Dot) in another clear attempt to drive badly needed volume, and the Google Home Max ($399) which goes up against Sonos and Apple HomePod.  The broadening of the portfolio should help Google increase its penetration of the home but the smart home piece is still badly lacking. Google claims that 1,000 devices from 100 manufacturers now work with Google Home but it failed to demonstrate any and instead concentrated on products from Nest.
Google also launched routines which is exactly the same as the Amazon Echo function of the same name and something that all smart home controllers need in our opinion. The integration of Google Home with other Google devices and the functionality being added is far ahead of anything else available but the smart home bugbear continues to rankle. This means that anyone serious about smart home is likely to choose Amazon simply because they know that anything made for the smart home will work while the same cannot be said for Google. This needs to be fixed and will remain the reason for Google’s potential defeat at the hands of Amazon because elsewhere it is by far the best product available.

Two companion products were launched for Google Accessories which deepen the cross-device functionality as well as highlight Google’s core AI strengths. The Pixel Buds ($159) which take aim at Apple’s popular AirPods (also $159) and while the design looks inferior, the functionality is excellent. This includes an exciting implementation of Google Translate that works with the Pixel phone to enable usable voice translation in 40 languages. It also allows easy access to the best in class Google Assistant in a similar way to AirPods. The difference here being that Google Assistant is a substantially better service than Siri. Google Clips ($249) was also launched. This looks like a regular GoPro or Yi camera but the differentiator lies in its functionality. The idea with clips is to position the device during an event or gathering and leave it to gather the best photos and video clips. Again, this is Google using its leadership in AI to differentiate and if this feature works well, we suspect that it will be a very good reason for users to buy this product. The number one use case for GoPro and Yi cameras is family despite their sporting image and it is this use case that Google is taking aim at. If it works well and gains traction, this spells more trouble for GoPro which has struggled with software and ecosystem from Day 1.

Google has substantially deepened its cross-device capability with the new launches as these devices should all work extremely well together. We think that Google comfortably leads the industry in this capacity. Furthermore, much of the functionality that Google has demonstrated should make its way onto the Android devices from other manufacturers driving which should really help penetration. How well they work on the hardware of others is a concern as manufacturers tinker with Android that always seems to result in inconsistent and subpar performance of apps and services. Consequently, in terms of driving deeper and richer services for its ecosystem users, this was a successful event but the real question remains what volumes will Google’s own hardware achieve?  These services will obviously work better on Google controlled hardware where the endemic fragmentation and lack of software updates are not an issue. Execution and marketing are the two things we are looking for from Google as to date, these have been woefully lacking.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

5 October 2017

Android - Further deterioration

Apple is 577x better than Android

Both Android 8.0 Oreo and iOS11 have been available for a few weeks and has highlighted, once again, how bad the situation in Android. This has a fundamental impact on the Android user experience, loyalty and monetisation.  Data from android.developer.com shows that Android Oreo is present on 0.2% of Google Android devices while iOS11 is present on 38.5% of all iOS devices. Furthermore, Android Oreo has been available for 44 days (August 21st 2017) while iOS has been available for just one third of that time (15 days, September 19th 2017). This means that the iOS user base is, on average, being upgraded 577x more quickly than Google’s user base of Android devices.

To compound the problem, it looks as if the rate at which the user base is transitioning to newer versions of Android is slowing down. 12 months ago, Android 7.0 Nougat had 0.1% share of the user base and currently it has just 17.8%.  At this rate it will take 5 years and 7 months for Oreo to completely penetrate Google’s own Android user base. This is substantially worse than the 4 years observed in previous years. This means that when Google makes an innovation in functionality that requires a modification to be made to the underlying Android OS, it will take the best part of 6 years for this innovation to make it into the hands of all of its Android users. By contrast this process is essentially complete on iOS devices within about 3 months.

Effectively Google is spending money on R&D that stands to benefit its competitors more than it benefits itself. If Apple takes a fancy to something launched at Google i/o, it can include the innovation in its latest version and have it deployed to essentially all of its users long before Google Android makes double figures. This combined with the endemic fragmentation, substantially hampers the user experience on Android making it inferior to iOS.

There is a substantial financial upside for Google if it can fix this problem which is why Google Android will eventually become fully proprietary. This is the only way by which Google can fix these problems and it comes as no surprise that both Android Auto and Android Wear are fully proprietary. While the status quo persists, Apple profitability on iPhone is unlikely to be challenged although we are much more cautious around revenue growth. We continue to be indifferent to both Apple and Alphabet, preferring instead, Tencent, Baidu and Microsoft.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

4 October 2017

Ola vs. Uber - Turntable

Ola has one chance to turn the tables on Uber

Ola has one chance to turn the tables on Uber. Ola has secured $2bn in funding from Softbank and Tencent which it must immediately put to good work if it is to wrest the advantage from Uber in India. This is an excellent time for Ola to receive a large cash injection as it is almost neck and neck with Uber in India and has the advantage of focus while Uber fights endless fires elsewhere. This advantage will not last for ever and if Ola can push its share back to 60% it will stand a chance of doing to Uber what Didi in China and Yandex in Russia have done before it.

Car hailing is one of the best examples of a networked economy and, just like classifieds, it is extremely difficult to make money until one of two criteria are met. First one must have at least 60% market share or second one must have double the market share of the next largest player. Data in terms of market share has been somewhat unreliable but it looks as if Ola has been able to cede only a small amount of market share in the last 12 months. Research by KalaGato Pte shows that Ola’s share in July was around 44% with Uber on 50% with everyone else fighting for the scraps. In October, Ola’s market share was around 50% (see here) and it looked to me like Ola would only survive with state intervention. During March 2017 Ola’s rides per customer stood at 2.95 while Uber were 4.38 with 40.9% of Uber customers paying less than Rs100 per ride while only 31.4% of Ola’s customers paying less than Rs100. While not definitive, this data indicates that Uber has been gaining share through aggressive pricing and the good user experience offered by the app. However, Uber’s troubles have had a massive ripple effect right the way through the organisation resulting in the eye coming off the ball.

It is this that has given Lyft a new lease of life in USA and now offers the same chance to Ola. This turmoil has only intensified with Transport for London denying Uber a license to operate necessitating even more diversion of attention away from India.
This $2bn investment and Uber’s focus elsewhere gives Ola a chance to halt its recent losses and turn them around. What it has to do appears to be quite clear. Firstly cut prices and second improve the usability of its app and service.
If Ola can get back to 60% share then it will have reached the hallowed status at which it will be able to generate cash and Uber will not.
It is at that point it will be in a position (as long as it holds onto 60%+) to eject Uber from India (probably through acquisition) but not before.
Now it all comes down to Ola management’s ability to execute and upon this, everything depends.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

2 October 2017 · 3 min read

It is difficult to see how Dyson will compete effectively in this market

Vacuum cleaner maker Dyson has announced that it will be producing an electric vehicle that has more hallmarks of the Sinclair C5 than the Model S.  Dyson intends to produce a fully electric vehicle by 2020 which will feature solid state batteries, which is one of the holy grails for battery technology as lithium batteries can be extremely dangerous when exposed to physical trauma, overcharging or excess heat, and has been a focus of Dyson for some time (but whether it has cracked this thorny problem remains to be seen); electric motors, which given Dyson’s history with household products, would seem a natural progression into electric vehicles and a premium price - Dyson is sticking to what it knows in positioning its vehicle at the high end but in this segment, it will face fearsome competition.

There are two critical attributes that will be required to succeed in a world of electric vehicles – automotive experience and digital data and Dyson has neither. As Apple has already found, making cars is extremely difficult and requires a lot of upfront investment. Dyson plans to invest $2.6bn in developing its vehicle which is not that much compared to everyone else investing in this space. Consequently, it has a lot to learn and not much money to invest which will leave it wanting.
An understanding of digital data is also vital, the importance of data generation in vehicle is likely to be critical for the success of the OEMs in the long-run. Players such as Google, Apple, HERE and TomTom are pushing hard in this space with OEMs such as Tesla and BMW already working hard to improve their differentiation using sensor data. Dyson’s current product line up does not have any data collection nor does the company have any real experience with regard to using data to make its customer experience better.
Dyson is firmly in the ship and forget category rather than the ship and remember that is essential going forward and most of the money in the automotive industry currently is made through the financing of vehicles and here Dyson also has no experience. Consequently, Dyson is pinning its hopes on differentiating via its battery.  Range anxiety and charging are two of the biggest limitations of electric vehicles today and if Dyson can offer differentiation by fixing either of these two problems it may have a chance.

That being said, the secret to solving these problems most quickly lies in making lithium batteries safer rather than using another substrate entirely. According to Amionx 50-80% of the weight of an electric car battery is made up of packaging to protect the battery against the kind of trauma that will cause a battery fire. If the battery can be made resistant to physical trauma, overcharging and heat then the weight of the package can be substantially reduced. This would enable a much higher capacity battery to be used for the same weight giving a big increase in range.

It is likely the solution is going to come before solid state batteries meaning that range will not be something with which Dyson will be able to differentiate.  Consequently, it is difficult to see how Dyson will compete effectively in this market as it lacks almost all of the core competences that are required. It will be up against the biggest automakers which are already shipping in big volumes as well as the biggest ecosystems who have tens of billions of dollars to invest.

It has been 17 years since arguably the biggest disaster in British innovation (Sinclair C5) but perhaps we are due for an upgrade.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

27 September 2017 · 4 min read

Indian E-Commerce: Amazon is the only real winner from the strategic choices being made by Flipkart

Amazon goes for the jugular. Amazon is not content just to let its rivals gift it the Indian market through their own bad decisions but is going for the jugular by opening up a second front in bricks and mortar retail. Amazon is buying a 5% stake in Shoppers Stop for $28m which will enable Shoppers Stop to increase the number of stores it has by 25% thereby expanding its reach into smaller towns. Currently only 5% of retail sales are made online in China meaning that for at least some time to come it will be an advantage to have an offline presence. This is exactly the strategy that Alibaba is pursuing in China and is looking to improve the poor offline experience by adding in technology and know-how garnered through its growth online.

All of Shopper Stop’s stores will play host to Amazon experience centres in order to educate and inform users with regard to the benefit of e-commerce. Shoppers Stop’s will also have an exclusive flagship store on Amazon’s Indian website which will help Amazon deepen its offering to Indian consumers. This is yet another blow to the local players Flipkart and Snapdeal whose inability to merge looks likely to hand the Indian market to Amazon. Flipkart, Snapdeal and Amazon are network businesses just like Uber, Alibaba, AirBnB, Craigslist and so on and consequently, they are bound by the same rules. 20 months ago we proposed a rule of thumb that states a company that relies on the network must have at least 60% market share or be at least double the size of its nearest rivals to begin really making profit.

Together, Flipkart and Snapdeal would have just about hit this threshold and with flawless execution might just been able to see off the threat from Amazon. However, Snapdeal recently ended merger discussions with Flipkart in a move that could easily hand victory to Amazon. Furthermore, having been soundly beaten in China by Alibaba, Amazon is absolutely determined to win the Indian market and we estimate that it is currently burning at least $400m per quarter to make that happen. The move by Snapdeal demonstrates a fundamental misunderstanding of how Amazon works and what it is likely to do to win the Indian market. Most companies have a strategy that involves trade-offs such as offering high quality or low prices. This is the route that Snapdeal is taking by deciding to streamline and focus on giving sellers the best experience in India. This is not how Amazon functions as there is no either / or in its vocabulary.

Instead Amazon goes for dominance and offers high quality and low prices or in this case the best experience for both sellers and buyers. Even with extra backing from Softbank, we do not think that Flipkart has the depth of management or the financial resources to withstand this ruthless onslaught and we think that it is unlikely to ever make a good return for its shareholders. The outlook for Snapdeal is even worse as it is much smaller with far less to invest. Amazon will now be able to grind its two main rivals down to the point at which they either exit the market or agree to be acquired. Both of these scenarios are likely to result in much lower valuations than were being discussed as part of the merger. Hence, Amazon is the only real winner from the strategic choices being made by Flipkart and Snapdeal. However, in the short-term $400m cash burn per quarter is unlikely to help Amazon’s fundamentals much and so we remain unenthused with an investment in its shares.
We continue to prefer Tencent, Baidu and Microsoft.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

22 September 2017

Troublesome hardware. Snap Inc. is admitting that it made a wrong turn with its spectacles

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, while 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 we 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 which 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.

Fair value for Snap remains around $12.40 per share which is still 10% below where the shares are today and negative sentiment could push the shares closer to $10 at which point acquirers could start to take interest. Until then we still see no reason to get involved and would strongly prefer Twitter to Snap Inc.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

22 September 2017 · 3 min read

If Google is prepared to be as aggressive on price as Xiaomi, it might just get somewhere

Google – Thrice bitten, never shy. Fourth time unlikely to be the charm. Google has announced a partnership with HTC that sees some key engineering talent join Google but it remains a complete mystery as to what Google is paying money for.
This will represent the fourth major hardware related transaction that started with Motorola Mobility and continued with Nest and Dropcam.

These deals all had two things in common. Firstly, all of the acquired companies have felt great discomfort being owned by a company that does not really understand hardware. The result was infighting and a failure to use Google’s strengths to increase market share of the products in question. Secondly, in each case the real beneficiaries of the transactions were the owners of the assets being sold, leaving Google shareholders considerably worse off. Even with highly hardware-experienced management, these assets have struggled to perform, leaving me with the impression that just being inside Google is enough to put good hardware people off their game.

The case with HTC will be a little different as Google is not buying the whole company but instead is paying for some IP and taking on some engineering talent. This is where we are left scratching our heads as on our numbers, HTC’s smartphone assets currently have negative value. One possibility is that Google is simply pre-paying in order to guarantee capacity and resources such that the previous ramp-up problems that occurred with Pixel do not happen again. This will also provide the infrastructure and distribution to produce Pixel smartphones in high volumes, something with which last year’s product really struggled. We do not think this deal is about promoting pure Android as Andy Rubin’s Essential Inc. is already pushing this button with great energy.

Hence, this is about bringing smartphone production and distribution to scale and if Google is prepared to be as aggressive on price as Xiaomi, it might just get somewhere. The real risk to this transaction is once again Google’s culture which has made the other hardware acquisitions feel like unwanted orphans that have no business being part of Google. Google has yet to show any sign that it has learned from the mistakes but better late than never. We continue to be pretty ambivalent to Alphabet whose valuation has kept in step with the improvement of its revenues generated by mobile devices. Tencent, Baidu and Microsoft look more interesting.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

19 September 2017 · 2 min read

Amazon still has the upper hand which it is showing no sign of losing

Amazon increases its aggressive land grab.  Not content to sit on 70% market share, Amazon is aggressively compensating for the lack of Alexa on smartphones by effectively giving the devices away and pushing e-commerce as hard as it can. A land grab strategy makes complete sense because the more Amazon can drive Alexa usage, the more data it will generate and the better it can become. Usage is the key to making all digital assistants better and this is the one area where Amazon has huge ground to make up compared to Google.

Amazon has launched yet another Alexa device which costs $20 but this is immediately credited back to the user when it is registered with an Amazon account making it effectively free. The latest addition to the family is called the Amazon Dash Wand which can be used to scan bar codes or Alexa to order products from Amazon. Alexa is present on the device and while this is clearly aimed at driving e-commerce, there is no reason why it can’t be used to answer inquiries or control the smart home. The one thing it won’t do is play music or radio but when the whole device costs $20, it is obvious that the audio experience would not be worth the effort. At the same time, Amazon is also offering $50 off the Amazon Tap reducing the price of the portable speaker to $79.99.

The two weaknesses of Amazon in the digital assistant space are that it is inferior to Google and that Google Assistant is present by default on every Android smartphone that ships. This means that if Google can convince users to use their smartphones to access the digital assistant, then Amazon will be at a big disadvantage. However, at the moment over 60% of all digital assistant usage occurs when the user’s hands are busy with another task which obviates smartphone usage as the device almost always has to be removed from a pocket to be activated.
This, combined with the fact that Google is still really struggling in the smart home, is why Amazon still has the upper hand which it is showing no sign of losing. This move is clearly aimed at seeding as much of the market as possible before Google can get its act together. If a large number of households have Alexa which is working nicely with the other smart devices they have at home, it will be increasingly difficult for Google to win them back even with a superior product. This is particularly relevant given that the market is still lowly penetrated in USA and is almost non-existent overseas. Given Google’s very slow progress, we are increasingly of the opinion that we are witnessing a repeat of the VHS vs. Betamax battle. We continue not to like either Alphabet or Amazon (even if it wins the smart home) on valuation grounds, preferring instead Tencent, Baidu and Microsoft.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

13 September 2017

Apple - Worst kept secrets

. Face ID was the star of a show where everything had been leaked.

Face ID was the star of a show where everything had been leaked.
Apple launched its next series of products that brings its hardware into line with the best of Android but it is in the software where the differentiation will continue to be found.

iPhone X.
iPhone X brings Apple into line with Samsung in terms of screen design and quality (OLED) but it is in Face ID where the real leap in innovation lies. Face ID uses a 3D depth sensor and infrared camera to map the user’s face and then compare that against a previously captured map. Face ID promises to be fast and not fooled by photographs or even 3D models of the user’s face. It will also continue to recognise the user when wearing a hat or glasses or should the user grow a beard. This should be a big improvement on Samsung’s facial recognition which is slow and unreliable to the point where it is often easier and quicker to put in the PIN number.  Apple has also redesigned the home button press and multitasking commands into swipes that should be reasonably easy to adjust to. Beyond that there are incremental advances in the camera and image processing but at the end of the day, this device is all about the new screen. Apple has brought itself into line with the high-end of Android in terms of hardware specification meaning that the price premium will be all about the iOS ecosystem. Pricing is in line with expectations at $999 for the 64GB version and I estimate $100 more for the 256GB version. With Android struggling with endemic fragmentation and Samsung remaining very poor at software Apple remains at the head of the pack.

iPhone 8/8+.
Many of the improvements present in the iPhone X are also present in the iPhone 8 with the exception of the screen and FaceID. It continues to use fingerprint recognition on the home button and has a slightly improved screen although it is in the old configuration and is not OLED. It has the same photographic enhancements as the iPhone X and represents a steady upgrade to the iPhone 7 with pricing staying the same.

Apple Watch Series 3
Apple has recognised that almost all the usage this product is for fitness and is doubling down on this use case in the new version. New functions have been added that improve the performance of the device for certain activities as well as adding some new less common activities. The heart rate monitor has been improved to offer continual heart rate monitoring as well as resting and recovery heart rates thereby deepening its appeal to fitness. At the same time, Apple is taking tentative steps into medical with the launch of a study that looks at alerting users to abnormal heart patterns that can lead to strokes. This is a work in progress but Apple clearly intends to move deeper into this area as it is working closely with the FDA on this study. Apple has also added a modem to one variant of the Apple Watch which we continue to believe is completely pointless.  Apple has done enough to keep this category going but the real use case that will make everyone rush out and buy one remains glaringly absent.

Wireless Charging
Apple’s new iPhones have glass backs which enable wireless charging for the first time. Apple has backed the Qi standard which is also used by Samsung which will now ensure that Qi becomes the single global standard. Apple also discussed a proprietary product that enables multiple devices to charge on a single mat but as this is not in the standard it will only work with Apple products. Apple is moving into line with everyone else on wireless charging as even the multiple devices on one mat is not a new idea.

Take Home Message
The endless leaks and speculation meant that Apple was not able to spring a single surprise on the audience this year. That being said, it has done just enough to keep itself at the top of the industry for another year. This is more about the Android camp struggling with software fragmentation and low profitability than Apple raising the bar for the gold standard in smartphones. The one area where it has raised the bar is FaceID but this feature needs to tested in the wild to see just how good it really is.

Apple’s share has enjoyed a great rally this year meaning that the valuation argument for owning the stock long-term has evaporated. With no real surprises coming this year there is a case to be made for taking some profits and looking elsewhere. Tencent, Baidu and Microsoft spring to mind.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

13 September 2017

Electric Vehicles - Extinction level event

EVs could trigger a huge decline in vehicle demand

Vehicle makers are queuing up to announce their commitment to electric vehicles (EVs) but at the same they may be cheering for their own demise. Volvo began it by committing to an EV line-up in 2019 followed by Chinese plans to ban all sales of fossil fuel vehicles and now Mercedes-Benz will offer a hybrid or electric version of its entire line-up by 2022. Unlike the optimists, we do not see EVs as the beginning of a new golden age for the vehicle makers but instead the trigger for a potential collapse in demand from which most of them will never recover.

Edison Research has concluded that owning an EV could easily halve the amount of money that the consumer spends on private transportation. This is because EVs should last much longer than internal combustion vehicles allowing them to travel 2-5x more miles than vehicles that use fuel before they need to be replaced. Assuming that EVs cost the same, they will be much cheaper to own when considering the cost to drive each mile. Furthermore, EVs have many fewer moving parts than internal combustion vehicles meaning that there is much less to go wrong and hence they will be cheaper to maintain. Most vehicles are driven to destruction meaning that assuming total miles driven does not increase, a vehicle market that is 100% EVs will be just 20%-50% of the size of the same market with internal combustion vehicles. In USA, this means a market of 3.4m – 8.5m light passenger vehicles compared to the 17m that are sold today. It is important to note that these estimates are extremely sensitive to small changes in long-term assumptions meaning that these forecasts are purely an indication of a scenario for which all players should be prepared. For the large, bureaucratic and slow vehicle makers (almost all of them), this represents an existential change in the market that most of them will not survive.

What is likely to then happen is a massive consolidation of the global market in to 5 or 6 vehicle makers down from the 26 or so that there are today. However, it is not all doom and gloom as from this shift, substantial opportunities are likely to emerge. EVs are all likely to be connected to the cloud with a myriad of sensors detecting events within the vehicle and its immediate vicinity. This data should enable a series of highly valuable services for which users will be willing to either pay for or consume advertising. As it stands today, the OEMs have a lock on this data and as long as they don’t let it slip to Google or one of the other digital ecosystems, they should be able to make a good return from it. We very much doubt that it would make up for the revenue lost from lower vehicle demand but it will be much higher margin than selling vehicles which should soften the blow.

Of the vehicle makers, we continue to think that BMW and Tesla have the best chances of survival but we think even BMW might struggle to survive a decline in demand of this scale

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

13 September 2017

Google Auto - Greek gift pt. III

Waymo’s time is now.

Google’s self-driving division, Waymo, is currently by far the best option for anyone looking for an autonomous driving offering with two caveats: Firstly, It is likely to come at a heavy price in terms of data and long-term differentiation. Secondly, by the time autonomous driving is critical, many of the other solutions may have caught up. Waymo is currently on a charm offensive trying to assuage the fears of automakers who have seen what Google has done to the smartphone industry and are fearful that the same could happen to them. One of the few assets that car makers are likely to have left as the world moves to electric vehicles (EVs) is the sensor data that these vehicles generate. Edison research has concluded that combining Digital Life data generated by the smartphone with the sensor data gives scope for substantial revenues to be generated.  There is no doubt that Waymo is currently by far the best at autonomous driving but in order to work, the system has to have full access to the entire vehicle. For any vehicle maker deploying Waymo, this means opening up the entire vehicle to Google thereby putting at risk the only real differentiating asset these companies are likely to have in the long-term.

Android Auto has proven to be ineffectual because while it displays apps running on the smartphone on the infotainment unit screen, it has no access to any of the sensor data that the vehicle generates.
This is why the announcement by Audi and Volvo at Google i/o that they will deploy full Android in their head units is so significant. By using Android instead of their own proprietary code, they may be letting Google gain access to the sensor data over which they must maintain control. Google did announce that the code will be “manufacturer tweaked” Android which we hope for their sake means that all access to the sensor data remains under the vehicle manufacturer’s tight control.

Waymo’s argument is that vehicle makers make no money on cars that have already been shipped and that with Google / Waymo there would be some kind of revenue sharing deal. Waymo has not said how much it is willing to give away but should it become dominant, we are pretty sure that the share will be very small. The good news for vehicle makers is that we do not think that they need to rush into any alliances for self-driving systems just yet. This is because we still think that the technology will be mature long before the market is ready to accept it which gives those that are far behind Waymo today a lot of time to catch-up. Consequently, by the time that autonomous driving becomes a vehicular requirement, we think that the playing field will be far more even with a good array of choices that do not necessarily include the sharing of sensor data.

We suspect that this is why Waymo is pushing its wares now as its chances of getting automakers to give Google access to their sensor data are at it their peak. Hence, vehicle makers should wait before making a deal for autonomy that they will not need for many years.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

8 September 2017

Huawei - The AI of others

Huawei needs its own algorithms to succeed in AI

. Huawei abandoned its habit of launching a new phone at IFA 2017 and instead focused on a new chipset called the Kirin 970 that promises all usual the bells and whistles as well as artificial intelligence. Huawei made some bold claims regarding its hardware performance as well as power efficiency thanks to its 10nm geometry but we get the impression that it intends to drive differentiation through its embedded neural processing unit (NPU). This is a part of the chipset that has been specifically designed to run AI algorithms more quickly and more efficiently than running them on the CPU or in the cloud. The result should be faster processing of AI tasks resulting in better services that drain the battery less.

This is all well and good but what really matters is what users of Huawei devices will notice, to whom they will attribute the value created and for what they will pay. The Kirin 970 NPU supports Huawei’s own APIs as well as Google’s TensorFlow and Facebook’s Caffe 2 meaning that AI created by these two ecosystems will also run optimally on the NPU. The idea is that the algorithms are created in the cloud, downloaded to the device where they run locally improving both speed as well as privacy as the data will not leave the device. We have long believed that this type of AI will be limited to functions where the algorithms are very well established. In the early days this is likely to be image processing such as facial recognition or computer vision. This is where Huawei will begin to struggle as it has very little AI of its own meaning that the Kirin 970 will spend almost all of its time processing the AI of others. The AI of others will be running on the devices of all of Huawei’s competitors meaning that Huawei will be competing purely in hardware performance.

When other chipmakers come to market with their own NPUs, it will then be a straight fight based on hardware performance. When it comes to AI, users are going to place value of the depth, richness and intuitiveness of the services themselves meaning that to improve its differentiation, this is where Huawei needs to compete. Of this there is no sign meaning that while the Kirin 970 may help Huawei increase market share, it will do nothing to enable it to increase the prices of its phones. The net result is that until Huawei can outsell Samsung by a factor of 2 to 1 in terms of volume, it will really struggle to increase its margins beyond the 2-4% that everyone else (except Samsung) is stuck with. Google is the only company that really makes money from Android but we continue to be cautious as its valuation is already pretty full. Tencent, Baidu and Microsoft remain our top choices.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

7 September 2017

Xiaomi and Google - Race to the bottom

Android One will only ever benefit Google.

Xiaomi and Google are resurrecting the Android One program but given what Xiaomi has launched, the original aim of Android One has clearly been completely abandoned. The idea behind Android One was to provide a reference implementation of Android optimised for Google’s services that would be used by multiple manufacturers. With multiple manufacturers on board and joint sourcing of components, the cost to make these devices would have been substantially reduced. This is how Google capable devices could have been economically put in the hands of users at much lower prices which in turn would drive usage for Google, highlighting the whole point of the exercise. However, handset makers need differentiation and so they all wanted to tweak the specification meaning that development costs would rise and that any volume discounts on components would be lost. The results were devices that were no cheaper to produce than anything else rendering the program useless.

Xiaomi has resurrected the Android One brand but is completely ignoring the point of the program with the launch of the Xiaomi Mi A1: a dual 12mp camera with 5.5” 1080p screen selling for an incredibly reasonable INR14,999 or US$234. The device abandons the MIUI user experience and ecosystem being pushed in China and goes soup to nuts Google. This is almost as much a Google device as the Pixel is. This is where the Xiaomi’s strategy comes unstuck as we have long believed that the Android One program benefits Google and no one else.

While the Mi A1 is a nice-looking device, it is still competing on the basis of hardware only meaning that all Xiaomi is doing is further accelerating the race to the bottom. Xiaomi’s strategy has been to sell hardware at cost and then generate profit through its ecosystem of software, services and connected devices. By going fully Google, this strategy goes completely out of the window as Xiaomi has no way to make money from its ecosystem. Consequently, unless it can outsell its closest rival by more than 2 to 1 (this would require beating Samsung) all it can really hope for is commodity margins at best. This might help Xiaomi to grow market share and revenue in India but it will do nothing for its profitability.

Xiaomi has staged a good volume comeback in 2017 but it is very far from a position where it can make good profits or offer a return to the long-suffering investors who put money in at $45bn.  We continue to believe the only winner in Android (outside of Qualcomm, MediaTek and ARM) is Google but that this benefit remains fully priced into the shares and prefer to look elsewhere.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

7 September 2017

Google - Yellow brick road pt. II

Another step to fully proprietary Android.

. Android Auto and Wear are fully proprietary and we continue to see incremental moves by Google that lead inexorably towards fully proprietary Android on smartphones. Following on from Project Treble, Google is now starting to clamp down on kernel usage by Android smartphone makers. The kernel is the small but critical software program in any computing system that has complete control over everything that forms part of that system. It is the first piece of software that is loaded after the device is booted and the Android OS runs on top of it. Because it has access to everything, the kernel is critical for security which is the reason that Google is has given for this action but it also has the convenient side effect of moving Google closer to a fully proprietary system.

To date, handset makers have been free to choose any Linux kernel they please (there are many) which has been a source of poor security and inconsistent performance of the same software on different systems. However, from Android Oreo forward Google has mandated that the minimum kernel version on new devices must be 3.18 (to be revised upwards with time) or newer and must enable Project Treble. These criteria are checked at the point of certification and again when the device software is upgraded over the air (OTA). This will certainly make an improvement to the very poor security that plagues Android but it should also improve the endemic fragmentation which continues to hamper the Android user experience keeping it behind iOS.

We have long believed that fragmentation combined with the inability to update the vast majority of its devices are the biggest factors behind the inferior user experience on Android which in turn has led to lower usage, terrible security and low loyalty. The effect of this can also be seen in Google’s financials where Edison calculates that, on average, Google still earns double the revenue from an iOS device running its services than from one of its own Google Ecosystem devices.

Consequently, there is substantial financial upside to improving the user experience on Android which we continue to believe will only be properly achieved by taking Android fully proprietary. This remains a slow process but increasing control over the kernel is yet another step along the yellow brick road to Oz. We continue to struggle with the valuation of Alphabet and hence still prefer Tencent, Baidu and Microsoft.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

7 September 2017

Apple - SiriKit?

There are very good reasons to launch SiriKit

Apple has made some changes to executive responsibility for Siri that we see are a sign that things are not going very well and that changes are required. Given Siri’s weakness, we do not see much downside for Apple in allowing third parties to implement the digital assistant in their hardware presumably using an SDK called SiriKit.

Responsibility for Siri has moved from services (Eddy Cue) to software (Craig Federighi) which is pointing to much deeper integration of Siri into the Apple ecosystem. The way this kind of development works is that the services are developed on top of the finished product of the software department. With Siri as part of the software department it can be much more deeply integrated as the software is created and refined which should allow its functionality to be meaningfully enhanced. However, what is unlikely to change is that fact that Siri is just not that smart and is easily outperformed by Google Assistant and even Amazon Alexa on occasion. This is due to the fact that Siri has not been in existence for very long and that its global learning capability is hobbled by Apple’s implementation of differential privacy. The net result is that Siri is falling behind in the AI race and moving Siri to software will not really solve the problem.

To really improve, Siri needs to be used and this is where the problems really begin. Usage of Digital Assistants primarily occurs when users’ hands are busy which currently means in the car and in the kitchen. Apple’s position in both of these areas is quite weak and a $500 Home Pod that is nearly 4x more expensive than Google Home and 10x more expensive than the cheapest Amazon Alexa device is unlikely to help penetration. Apple’s strategy to date has been to drive differentiation and desire through software that can then be monetised by selling hardware at premium prices.
This is why it keeps all of its software to itself but Siri can be an exception. Firstly, we do not think Siri is differentiating for Apple because it is a substandard service. Consequently, if it was removed from Apple products or allowed to appear on the products of third parties, we do not think this would affect Apple’s ability to price its hardware at a premium. Secondly, Siri is driven by AI and the AI community is far more open and collaborative than Apple has been historically. For example, DeepMind published its method for creating AlphaGo which in our opinion was then immediately copied by Tencent to create its own AI Go player.

Apple has opened up a little bit and has begun sharing and publishing some of its methodologies for Siri which we suspect will increase over time. As a result, we see only upside for Apple in making Siri available for third parties to put on their devices. Siri on third party hardware is very unlikely to damage Apple’s hardware business and at the same time could result in many more devices in the places where digital assistants are most used. The net result would also be more data collection and learning that would help make Siri better. This would represent a big departure from the way Apple has been doing businesses and there is a possibility that Apple has become too big and too set in its ways (like Nokia was) to make a departure of this magnitude. Consequently, the probability of Apple launching SiriKit is pretty remote which is will to allow Google and Amazon to continue dividing the market between them. Our top picks remain Tencent, Microsoft and Baidu.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

1 September 2017

Home vs. Alexa - Battle for the home pt. III

Google has everything to do

Battle of the home. Google is great at getting third parties to build hardware that uses its software, but needs to work on developers of smart home devices if it wants to trounce Amazon. Following the general availability of the Google Assistant SDK that allows anyone to embed Google Assistant into almost anything, Google has also announced a series of third party devices which will be launched at IFA next month. These include the Anker Zolo Mojo, the Panasonic GA10 and the TicHome Mini all of which will go on sale during Q4 17. Amazon has followed suit but as of yet, there appears to be less traction with hardware makers.

Alexa is likely to power the next generation of Sonos speakers and may make an appearance in some VW cars but it looks like Google has more momentum when it comes to hardware. This is likely to ensure a race to the bottom in terms of voice enabled smart speakers from which Google will be the only likely winner (just like Android). It badly needs to close the gap on Amazon which has around 70% of the home speaker market and having a much wider selection of attractively priced products will be of great help. What will further help Google is the fact that Google Assistant is a vastly superior product compared to Amazon Alexa. This is because the AI that sits behind Google Assistant is the best available, meaning that Alexa answers fewer questions correctly and gets stuck much more often. However, where Google comes completely unstuck is in the smart home.

Amazon has aggressively pursued developers and showered them with love and support meaning that almost every developer of anything that has a Bluetooth or WiFi radio can be controlled with Alexa. The same cannot be said for Google Assistant which has been caused by Google’s surprising lack of support for developers of this type. Part of the reason for this is that Google Assistant has been brought to life by one part of Google (hardware) but was created and managed by another. Google is addressing this by encouraging developers to write directly to the assistant meaning that any device be it a smartphone, speaker or thermostat can run the smart home but progress to date has been slow.

Amazon Alexa has over 15,000 skills which don’t work very well but importantly, there are there and do work with a little effort. Google Assistant is hopeless by comparison and it is here that it is at real risk of suffering a Betamax-like defeat. Google needs to bring all of these devices together such that “OK Google, I am going to bed” results in the whole house shutting down rather than a long series of carefully constructed instructions to each device individually to go into night mode.

For many of Alexa’s skills, it is simply easier and quicker to perform the operation manually than to ask Alexa to do it. Unfortunately, so far there is no sign of smart integration from Google meaning that the advantage remains with Amazon. The market remains very lowly penetrated meaning that everything is still to play for but this won’t last forever.
Valuation keeps us from liking Alphabet and Amazon leaving Microsoft, Tencent and Baidu as our top choices.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

8 August 2017

Samsung Bixby - Lightweight

Bixby is hopelessly outclassed

The voice piece of the Bixby digital assistant has finally launched but despite months of feverish activity trying to teach Bixby to speak English, it is still not very good at it. Bixby has been granted exclusive hardware access such that it can work when the screen is off or the device is locked. This is something that Google Assistant cannot do but it also comes with the reality that Bixby is always listening. This will make some users very uncomfortable as a microphone in one’s pocket is far more intrusive than a microphone listening in the kitchen.

Voice recognition works best when there is an element of training involved as users often say things in very different ways. Unfortunately, it appears that for some users, Bixby is unable to recognise the training sentences implying that this part of the system still needs work. In effect Samsung has programmed Bixby with a series of standard functions that can be used to operate the smartphone as well as basic functions in the apps. Outside of that area, the user is pretty much out of luck. Unfortunately, these only really work for Samsung apps which outside of the messaging app for SMS, I think no one really uses.

For navigation and search, Bixby uses Google but without some of the bells and whistles that make Google so good and for these functions, it makes no sense to use Bixby when one can go straight to Google. Bixby does support third party apps through the “Bixby Labs” program but unfortunately it doesn’t seem to work properly and while it can open things like Google Maps, YouTube it does not seem to be able to get past the main screen of those apps.

The problem with Bixby is simply that its creator, Samsung, has no artificial intelligence expertise to speak of and digital assistants are only about AI. Google Assistant is the best not because Google knows how to make an assistant but because the AI that runs it is the best in the world. This contrast is so stark, that Samsung has had to resort to hobbling Google Assistant in certain areas just to give Bixby a chance. I think that this will encourage users to try Bixby once or twice but when they realise how poor it is, they will go back to Google Assistant.

Google will not be losing any sleep over Bixby even though it could end up on a very high percentage of Google ecosystem devices. Samsung is now the No. 1 semiconductor manufacturer in the world, but I still rank it almost dead last when it comes to AI. Its investments in this space would be better accruing to shareholders via higher profits rather than being invested in functions that are likely to damage Samsung’s reputation rather than improve it. Samsung’s recent rally has removed the valuation argument for Samsung which leaves us preferring Tencent, Baidu and Microsoft.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

7 August 2017

GrubHub - Big Appetite

Eats24 is an essential acquisition

GrubHub is making exactly the right moves to give it the best chance to beat its larger and much better financed rivals in the brutal food delivery business. Alongside results that broadly met expectations, GrubHub announced the acquisition of Eat24 for $288m well over double what Yelp paid for it in February 2015. This may seem to a huge premium but when one looks at what Eat24 can bring to GrubHub, it is not difficult to make the case that this could be the most important move GrubHub has made in its history.

GrubHub is an online marketplace where diners come to order amd have delivered food from participating restaurants. As an online marketplace (network business) it is subject to exactly the same dynamics as ride hailing, classifieds and so on. 20 months ago we proposed a rule of thumb that states: A company that relies on the network must have at least 60% market share or be at least double the size of its nearest rivals to begin really making profit.  In effect, by hitting one of these two criteria the marketplace becomes to the go-to place to transact meaning that buyers become somewhat less price sensitive and sellers will pay more to sell their goods there. It is this that allows the marketplace to make proper money but before this level is reached all players will almost certainly be under excruciating pressure. GrubHub is no different in that since the advent of UberEats and Amazon’s entrance into this space, there has been relentless pressure on margins.

In the last 12 months EBIT margins have fallen to 13.9% in Q2 17A from 18.7% in Q2 2016 despite a 32% increase in revenues. GrubHub is the market leader with 34% but Uber is not that far behind with 20%, Eats24 with 16% and Amazon on 11% (Cowen &Co). Regulatory scrutiny has been high on GrubHub’s previous acquisitions but the fact that this deal is likely to be passed with barely a ripple is an indication of how much more competitive the market is now considered to be. There is some overlap between GrubHub and Eats 24 but importantly once combined the platform will have 75,000 unique restaurants on its books and 48% market share of transactions. Assuming that the acquisition and integration proceeds flawlessly, then GrubHub will be more than double the size of its nearest rival (Uber) and able to at least stabilise its margins. Furthermore, as long as it can hold onto this advantage, it should be able to withstand the pressure from its rivals despite the fact that they have very big brothers backing them up. Consequently, GrubHub had to make this acquisition otherwise it faced being ground down by its better financed rivals until it was forced to sell itself to one of them.
GrubHub has made the right strategic move to ensure its longevity but now it comes down to execution to determine its future.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

4 August 2017

Spotify - Free foundation

Apple Music still making no dent

Spotify has crossed 60m paid users and while its absolute level of growth is slowing due to the law of large numbers, it is still adding paying subscribers at the very healthy rate of 2m per month.

In September 2016 Spotify hit 40m, passed 50m in March 2017 and hit 60m at the end of July 2017. For the last 18 months, Spotify has been steadily adding subscribers at around 2m per month which is showing no signs of slowing down. This has held steady for the last 5 months indicating that Apple Music is having very little impact on Spotify despite the substantial advantage Apple has in owning the App Store and having complete control over the iPhone.

This is for two reasons. Firstly, Spotify remains fundamentally a better service, driven by the fact that the music is now incidental in that anyone can create a service with 40m tracks and a search box.
Where Spotify is different is that it uses the data that it collects from all of its users in order to make its service better. Apple also does this but Spotify’s AI in music continues to meaningfully outperform Apple’s. By understanding the characteristics of the music offered by its service and the preferences of its listeners, it can accurately match the two together. This also allows it to come up with innovative services that keeps its service fresh and one step ahead of the competition.

Secondly, Spotify has a large and engaged free tier of users that serve as the funnel for conversion into paid users. Free users get to spend time with the service without paying for it, making it much easier to make these users understand why the service is better than anything else available. This meaningfully offsets the disadvantage that Spotify has compared to Apple when it comes to marketing.
These free users generate data which Spotify can use to train its algorithms which can in turn be used to make the service better. Apple also has a lot of data but has not been nearly as good at turning raw data into actionable intelligence with which it can improve its service. The net result is that Spotify’s position is strengthening with every new user that it adds and between them, Apple and Spotify account for almost all of the growth in the recorded music industry. Consequently, we remain unconcerned that Apple will be able to put real pressure on Spotify and think that its path to better profitability remains clear as the labels increasingly need Spotify more than Spotify needs the labels. This position is becoming clearer as Spotify was able to strike a better deal with Universal and the outlook is that the rest of the industry will be signed on similar terms.

The key issue for Spotify going forward is to maintain momentum of growth of its free users. It is the free user pool that has been the foundation of its outperformance of Apple, meaning that the free tier will be critical to keep the paid tier (where the real money will be made) increasing at this very healthy rate. We continue to think that there is enough space in this market for 2 big players and with those spots filled, it is the fortunes of Pandora, Tidal, Deezer and so on that trouble us now.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

3 August 2017

India e-commerce - Road to ruin

The only likely winner in India is now Amazon

Snapdeal has ended merger discussions with Flipkart in a move that snuffs out the one chance the local players had to keep Amazon at bay. At the same time Softbank is now looking at committing $1.5bn – $2bn into Flipkart in a move that will solve nothing because in a network economy, two halves do not make a whole.

Softbank should not put any more money into Indian e-commerce as the most likely winner in this market is now Amazon in which Softbank has no stake. Snapdeal’s strategy is now to become a niche player and is cutting costs and selling assets in order to raise the capital required to reach profitability in its niche. This strategy demonstrates a fundamental misunderstanding of how Amazon works and what it is likely to do to win the Indian market. Most companies have a strategy that involves trade-offs such as offering high quality or low prices.
This is the route that Snapdeal is taking by deciding to streamline and focus on by giving sellers the best experience in India.

This is not how Amazon functions as there is no either / or in its vocabulary. Instead Amazon goes for dominance and offers high quality and low prices or in this case the best experience for both sellers and buyers. How Flipkart will alter its strategy following the failure of the merger remains to be seen, but without the scale that Snapdeal would have given it, its chances of seeing off Amazon are greatly reduced. Flipkart, Snapdeal and Amazon are network businesses just like Uber, Alibaba, AirBnB, Craigslist and so on and consequently, they are bound by the same rules.
20 months ago we proposed a rule of thumb that states a company that relies on the network must have at least 60% market share or be at least double the size of its nearest rivals to begin really making profit. This, in a nutshell, is the problem faced by both Flipkart and Snapdeal in India.

Flipkart is bigger than Snapdeal and so it is in a slightly better position, but it is not double the size of its nearest rival. Furthermore, both will now have to contend with Amazon which is absolutely determined not to make the same mess of India that it made in China when it went up against Alibaba and lost. We estimate that Amazon pumped $400m of losses into the Indian market in Q1 17A and roughly the same amount again in Q2 17A and I don’t think it will be afraid to up the ante from here if needed. Amazon is not the largest in India but it can lose far more money for far longer than either of the other two. Flipkart has around 35% of monthly active users but it will need to reach at least 50% before it is double the size of Amazon (7Park Data).

This is why a Snapdeal merger made sense, because adding Snapdeal’s users to its own would have got it pretty close to achieving that milestone. Consequently, Amazon will now be able to grind its two main rivals down to the point at which they either exit the market or agree to be acquired. Both of these scenarios are likely to result in much lower valuations than were being discussed as part of the deal. Hence, Amazon is the only real winner from the failure of this merger which raises existential questions for local providers of e-commerce marketplaces in India.
In the short-term this is unlikely to help Amazon’s fundamentals much and so we remain unenthused with an investment in its shares. We continue to prefer Tencent, Baidu and Microsoft.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

2 August 2017

Apple FQ3 17A - No pause here

Solid base for new product launches.

Apple reported good results and guided strongly for the coming quarter stoking speculation with regards to the possible strength of the coming upgrade cycle with the new iPhones expected to be launched next month. FQ3 17A revenues / adj-EPS were $45.4bn / $1.67 slightly ahead of consensus of $45.0bn / $1.57.
While iPhone held steady it was Services that really underpinned the results with YoY growth of 22% to $7.3bn. iPhone shipments were 41m which included a 3.3m inventory reduction ahead of the new launches. iPad shipments were 11.4m up 15% YoY driven mostly by the product refresh that saw a new iPad and the smaller version of the iPad Pro launch in March 2017. Mac shipments were 4.3m units driven mostly by the new MacBook Pro.Services was the star of the show where the Apple App Store is the main driver generating almost double the revenue of its nearest rival Google Play.
This was despite the fact that Android devices appear to have closed some of the monetisation gap on iPhone especially at the high end.  Guidance was surprisingly strong with revenues / EBIT expected at $49bn – $52bn ($50.5bn) / $11.7bn – $13.0bn ($12.4bn) broadly in line with consensus at $50.4bn / $12.4bn. The result was a relief rally as fears of a pause in performance ahead of the new product launches now looks unlikely to occur. Consequently, all eyes are now on product launches where a major product refresh is hoped to trigger another replacement cycle.
Bezel-less devices are now all the rage and if Apple can replace fingerprint ID with an excellent facial recognition system, the iPhone 8 could end up triggering a good cycle of upgrades.
Samsung has a wealth of biometric ID systems but none of them work particularly well as the fingerprint sensor is on the back of the device and the facial recognition is not nearly as reliable as it should be. We do not think that Apple will see a cycle as strong as the iPhone 6 but there is potential for the iPhone 8 to meaningfully outperform the 6s and the 7. That being said, we continue to think that much of this good news is already in the stock and the valuation argument for long term investors has long since evaporated.
We remain pretty indifferent to the shares.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

1 August 2017

iOS vs. Android - Catch-up

Android is snapping at Apple’s heels.

Android is showing signs of catching up with iOS in terms of user spending at the high-end, but further down the pricing tiers and in mobile advertising, iOS remains miles ahead. A recent study of the habits of 1.4m USA based users during the month of June 2017 was carried out by DeltaDNA, an analytics firm. The study only measured gaming but this is already well known to be by far the biggest revenue generator from any Digital Life segment. Almost all games these days are free to play and have in-app purchases for monetisation. It is these that the survey measured and we have expressed these as ARPU $ / month.

Samsung Galaxy s8 / s8+: $6.30 / $16.20
Google Pixel / XL: $6.30 / $9.60
iPhone 7 / 7+: $8.40 / $10.80
Other US Android devices: $6.00

From this we conclude that firstly, screen size and quality is a big determinate in game monetisation. The Samsung Galaxy s8+ which has by far the best screen, and the best audio in our opinion, available on the market today, is clearly making a difference to game play with the observed results. Secondly, on normal screens, iPhone is still comfortably ahead of both the s8 and the Pixel but the gap is closing. Thirdly, both the s8 and the Pixel are not meaningfully better than other Android devices implying the that user experience on the s8+ and Pixel XL has nothing to do with their better monetisation. Although these models are clearly closing the gap on the iPhone, when it comes to total revenue generated there still remains a vast chasm in terms of total revenues generated. In Q1 17A, Apple generated $7.04bn in revenues from services while Google other revenues were $3.10bn ($3.09bn in Q2 17A). These figures are not direct comparisons as there are other businesses also included in these figures, but it is pretty safe to say that Apple App Store is easily generating double the revenue of Google Play.

A large part of this will be because in the high-end segment Apple has much higher share but also because Apple does still clearly offer a higher quality apps and services experience as the data for the regular sized phones indicates. Furthermore, we have not seen a shift in the mobile advertising metrics and so we still believe an iOS device generates double the advertising revenues of an Android device. This data should send a warning shot across Apple’s bows as the better Android devices are certainly snapping at its heels. Should they finally catch up, Apple may find it starts to feel the dreaded pricing pressure that will hurt profitability. This is why we continue to believe that Apple needs to make its ecosystem sticky in areas other than its App Store which is what its strategy around HomeKit, HealthKit and Apple Pay are centred around.

However, to date, not a huge amount of sustainable traction has been generated by any of these services and so Apple has to radically improve them or think of something else. This is one reason why the iPhone 8 is so important as once again it has slipped too far behind the hardware curve and needs to catch up. With the rally that we have seen in 2017, the valuation argument for holding Apple has long since evaporated which is why we prefer to hold Tencent, Baidu or Microsoft for this year.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

31 July 2017

Amazon Q2 17A and Baidu Q2 17A - Back to basics

Amazon and Baidu get back to doing what they do best

vAmazon – Not making money. Amazon reported disappointing results and guided weakly as it once again spent everything it could on investing in future revenue growth.
Q2 17A revenues / EBIT were $38.0bn / $628m compared to consensus at $37.2bn / $1.0bn. AWS put in another mighty performance with revenues of $4.1bn and margins of 22% but this was gobbled up by the international operation where margins have fallen to -6.3% from -1.4% in Q2 16A. That is mostly driven by Amazon’s absolute determination not to lose India to Flipkart / Snapdeal the way it lost China to Alibaba. The good news is that Flipkart and Snapdeal are squabbling over their merger and the longer it takes them to get it done, the less chance they have to keep Amazon out of their home market. This heavy investment looks set to continue with Q3 17E guidance disappointing once again. Q3 17E revenues / EBIT are expected to be $39.25bn – $41.75bn ($40.5bn) / LOSS $400m – $300m (LOSS $50m) compared to consensus at $39.9bn / $1.1bn. There is no sign of this “bumbling around break-even” in sight and consequently the valuation of Amazon looks more stretched than ever. We prefer not to pay now for profitability that very fleetingly materialises.

Baidu – Performing in line with China. Baidu reported good Q2 17A revenues as the regulatory impact on its revenues has past and the company kept a tight lid on expenses.
Q2 17A revenues / net income were RMB20.7bn / RMB4.4bn compared to consensus at RMB20.7bn / RMB3.3bn. A large part of this improvement has come from cutting back on investments in its food delivery business but also from a big fall in traffic acquisition cost which fell from 15.9% of sales in Q2 16A to 11.9% in Q2 17A. Despite the cuts, investments in AI and content remain intact and are the two main thrusts for revenue growth beyond search. In AI, I rank Baidu highly, although it is very focused on China, and think that this is its biggest strategic advantage to remain a big player in Chinese Internet. Baidu should be able to make its services more intuitive and useful compared to those of its competitors which should help its services win and keep more users. The outlook for Baidu remains steady, now that the regulatory problem is in the rear-view mirror, and we see an upwards correction as it catches up with its peers.
We continue to like Baidu alongside Microsoft and Tencent.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

28 July 2017

Facebook Q2 17A - Cash community

Community is about cash generation

Facebook reported another set of excellent results and laid out pretty concrete plans of how it aims to put off, for as long as possible, the inevitable slowdown in its growth. Q2 17A revenues / adj-EPS were $9.3bn / $1.32 compared to forecasts of $9.1bn / $1.32. Mobile advertising, and especially video, underpinned most of the growth as mobile now accounts for 87% of total advertising revenues. Facebook now has 2.01bn MaU of which 1.32bn visit everyday.

Two major themes have emerged over the last 6 months which were further emphasised at these results. Firstly, community. Facebook is moving away from connecting friends (as it has already done this) and towards creating communities. There are already 100m members of groups around particular interests which Facebook aims to push much higher. These groups meet both virtually and physically and they represent an incremental monetisation opportunity. This is because they represent the most engaged users where their interests are as clearly defined as they are on Twitter.
This means that Facebook should be able to monetise them much more effectively as the advertisements served will be more relevant and therefore can be more highly priced.
Furthermore, should Facebook succeed in growing the membership of these groups meaningfully, the average time spent by users on Facebook will also rise. This will give both a price and volume lift to revenues allowing much faster growth.

Secondly, Artificial Intelligence. It is clear that this is Facebook main strategic priority. This is because it is very far behind the curve when it comes to the quality of its AI, and it badly needs to at least be able to understand and categorise the huge amounts of data that it generates every day. Facebook also intends to use AI to understand its users better so that it can suggest content that exists outside of their social circle in which they might be interested. This will also have the convenient side effect of enabling Facebook to target its users more effectively, thereby increasing the price it can charge to marketers. AI still remains a major weakness for Facebook but importantly, it is aware of the problem and is working on fixing it as fast as it can. Behind the desire to connect people and create communities lies a Sheryl Sandberg’s highly efficient cash collection machine. At the end of the day Facebook is a business not a philanthropic organisation and it is doing an excellent job of earning a good return from the data it collects. We still remain concerned with short-term growth due to the maturation of its core businesses and the fact that new areas like messaging and gaming have yet to really generate revenues.

So far in 2017, Facebook has been able to defy both its own (and our) forecasts for revenue growth but the comparisons are getting tougher and tougher to keep up this pace. Hence, we doubt that Facebook can keep this up until its new businesses mature and we still see a pause coming in revenue growth over the next 6 to 9 months. It is at that point, that we am looking to get in for the long term as Facebook is showing all the signs of becoming the biggest ecosystem of them all.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

27 July 2017

Facebook - Empty head

Another smart speaker that badly needs a brain

It looks like Facebook is joining the ever more crowded smart speaker bandwagon, but without a decent brain inside the box, it may as well be a paperweight. One possibility is for the device to use Cortana as it comes from one of the few companies that do not compete directly with Facebook: Microsoft. The device looks like it will be using a 15-inch screen from LG and will be manufactured by Pegatron but beyond that there are very few details. We suspect that Facebook may be trying to take a slightly different tack here because the smart speaker market is already very crowded, Facebook has no brain of its own to install in the box and it is more focused on community than smart home.

Facebook’s main objective in life is to bring its users closer together using its apps and to give them a sense of community. While this all sounds great for users, the reality is that they will end up spending more time inside Facebook’s fledging ecosystem, generating more traffic and thereby increasing Facebook’s ability to make money from them. Hence, we suspect that this device may be aimed more at making it easier for Facebook friends to spend time with each other by voice, video, messages or even images.

To earn a place on the increasingly crowded countertop of consumers, it is going to need voice functionality of some description. Facebook M, which is Facebook’s own digital assistant is hopelessly inadequate to fulfil this role, meaning that Facebook will have to get one from somewhere else. Top of the list for this is Cortana which, while not the sharpest tool in the box, it is the only one whose owner is not competing directly with Facebook.

We have seen Microsoft and Facebook creeping closer together over the last few years and this is a collaboration that could make some sense. With a bit of tinkering on Microsoft’s part, Cortana could be taught how to deal with the majority of the tasks that users ask smart speakers to perform. This work is probably already going as Microsoft may already be working on a smart speaker of its own. Combining this with the screen and Bing would give the device a reasonable shot at doing a decent job of answering queries. This is just another example of how badly Facebook needs to bring its AI up to a level at which it can compete on a level playing field with Google and would also help Facebook deal with the objectionable content problem that it has on its platform as its current answer to this is to throw more humans at the problem.

This has to be Facebook’s number one strategic priority and the progress displayed at F8 on image and video recognition was somewhat encouraging. We remain quite cautious with regards to Facebook’s outlook for this year as neither its video or gaming offerings are mature enough to bring the company back to high growth in 2017. This combined with requirement to really improve its AI to compete with the other digital ecosystems leads us to still prefer Baidu, Tencent and Microsoft.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

26 July 2017

Alphabet - Other people’s money

. Core businesses showing signs of maturity.

Alphabet reported good Q2 17A results but the fact that it has having to share more of its revenues with third parties is hurting profitability and indicates that growth in its core properties is maturing.
Q2 17A revenues-ex TAC / Adj-EPS were $20.9bn / $8.90 below consensus of $21.2bn / $10.34. While we consider the EU fine to be little more than an annoyance, it is the traffic acquisition cost (TAC) where we have concerns. Over the last 12 months, Google has been forced to pay away more of its revenues to its network members and distribution partners. Google network members are now keeping 72% of their turnover compared to 70% a year ago and distribution partners now get 11% of the revenues that Google generates from their devices compared to 9% a year ago.
The problem here is that this falls straight to the bottom line and looks to have been entirely responsible for the weakening of margins experienced during the quarter.

To a certain degree, what Alphabet is doing is buying growth in revenues and paying for it with lower profitability. This is exactly what Yahoo did much more aggressively prior to its acquisition by Verizon and it was able to mask a decline in its core business by buying in revenues from elsewhere. It implies that monetisation of its own properties and content such as search, mail, maps is starting to hit their capacity ceilings, leaving the company needing to find more growth from third parties. In this regard, the star of the quarter was YouTube which now has 1.5bn MaU with a staggering average engagement time of 60 minutes per day. YouTube is the main home of the alternative media which continues to gain substantial traction across the world as well as the place to go to learn how to do almost anything. YouTube has also seen very high growth of viewing from regular TV screens and is gradually making the move into traditional entertainment.
Machine learning and AI are found everywhere in Google’s products and given its lead here, it has the ability to make its services more useful and more intuitive than the competing services of other ecosystems.

Hence, the outlook remains pretty good for Alphabet but the underlying growth in the core business looks like it is maturing. Hence, profit growth could lag revenue growth as margins come under pressure from increasing TAC leading to more disappointment. We remain pretty cautious on Alphabet overall as the share price has more than kept up with the growth the company has enjoyed over the last 24 months. We still prefer Tencent, Baidu and Microsoft.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

25 July 2017

Uber vs. everyone - Colonial times

Uber’s dreams of colonisation are slipping away

First Uber lost China, then Russia and now it looks as if South East Asia may go the same way.
We aresure that Brazil and India are taking feverish notes. SoftBank and Didi are investing $2bn investment in Grab, the Singapore-based ride-hailing company that offers its services in 6 countries including Malaysia, Singapore, Indonesia, Thailand, Vietnam and Philippines. The total round is expected to be around $2.5bn with a post money valuation of $6bn.

Grab is present on 50m devices with 1.1m drivers and fulfilling 3m rides per day. Grab has two advantages over Uber. Firstly, dominance. According to Grab, it already has 91% market share in taxi hailing and 71% in private vehicle hailing in the markets it serves. This is crucial as our rule for online marketplaces states that to become to go to place to buy or sell a product or service, the marketplace has to have 60% market share or be double the size of its nearest rival. Assuming these figures are accurate (there was a lot of dispute in China), then Grab has already become to the go to market place although the opportunity is very lowly penetrated. We suspect that this is why it needs such a large fund raising as this position has to be maintained while the ride hailing becomes much more prevalent in the region.

Secondly, GrabPay. One of the problems with ride hailing in emerging markets is the fact that credit card penetration is very low. A large part of the ride-hailing experience is the ease and simplicity of payment and GrabPay is way to bring this experience to those with no credit cards. GrabPay credits can be purchased at ATMs, stores and banks (in a similar way to mobile phone airtime popups) which can then be used to pay for Grab services. This will remove one of the major hurdles to uptake of the service as this issue has made life difficult other offerings like EasyTaxi which operates in Latin America and the Middle East. Uber’s rivals overseas are making the most of its turmoil at home as while management attention is focused in USA, we suspect not much is going on overseas.
This gives its rivals more time to establish themselves and none of them appear to be wasting any time. The net result is that Uber’s dreams of colonising the world appear to be slipping away.

It will remain dominant at home and some key Western markets (like the UK) but it will have to do much more than just ride hailing in those markets to justify a $65bn valuation.
This is why autonomy may end up being so important as if Uber can capture a large piece of the gigantic $2.7tn transportation market in USA by operating a fleet of autonomous vehicles, then it could conceivably be worth 10x that figure.
However, Uber has a very long way to go before it gets to that point as its autonomous offering ranks dead last by Edison’s reckoning, and the car makers could well be fighting in this market for their very existence. We would not be surprised to hear of secondary transactions in Uber stock at well below $65bn and we can’t see much that’s going to push it up anytime soon.
One to avoid for now.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

21 July 2017

Microsoft FQ4 17 – Head in the clouds.

Not a cloud in the sky

A strong finish to the fiscal year cements Microsoft’s positions as the main alternative to Amazon Web Services and as the preeminent provider of a Digital Work ecosystem. FQ4 17 revenues / Adj-EPS were $24.7bn / $0.75 nicely ahead of consensus at $24.3bn / $0.71. Outperformance was primarily driven by Azure which grew by 97% YoY and Office 365 which showed continued to show healthy progress in both the enterprise and with prosumers. Gross margins improved slightly as favourable product mix was able to offset the impact of the increasing share of revenues coming from the cloud which has much lower gross margin than licence sales.
This is entirely normal and Edison research has shown that in Microsoft’s case in the long-run, it is better to have recurring revenues at lower gross margins than one off sales at much higher levels. This is because the one-off sales do not occur frequently enough to generate more profit than subscription revenues at much lower margins.
Consequently, gross margins are going to remain under pressure in future albeit at a lower rate as cloud gross margins are rapidly expanding as the businesses continue to scale.

Guidance for FQ1 18E was a little light with revenues / EBIT of $24.0bn / $7.1bn forecast compared to consensus at $24.2bn / $7.4bn. Guidance for FY18E remains unchanged with the priorities being placed upon increasing cloud gross margins and cautious growth in OPEX. While the Digital Work ecosystem is going from strength to strength, the consumer ecosystem continues to wither away. The one exception is gaming where the Xbox live community is still growing nicely and Microsoft remains the only real challenger to Sony in console gaming. Despite this, Xbox Live is a massively under-utilised asset is it has completely failed to get any real traction in mobile gaming.
This is why there may be a party out there that is willing to pay more for Xbox than it is worth to Microsoft. In that instance, Microsoft should sell Xbox in the best interest of its shareholders. Microsoft is not the most exciting company in the universe but it has been one of the steadiest over the last 2 years and there is every sign that this will continue into FQY 18E. Microsoft remains along with Baidu and Tencent, our two top picks.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

19 July 2017

Blue Apron - Size 12s

Amazon’s size 12s causes dismay for Blue Apron and Hello Fresh.

The saga of Blue Apron is rapidly becoming a horror story that could end in acquisition as rushing to IPO too early has now made it extremely difficult for the company to raise new money.

Blue Apron is a food delivery company that sends its members boxes with the exact ingredients required to cook entire meals at home. Members pay a subscription in order to receive a certain number of meals per week. It is exactly the same as Hello Fresh which operates out of Europe and is part of the Rocket Internet group. The proposition is quite simple in that by cutting out wholesalers and distributers it can offer good prices on high quality ingredients making the service inexpensive enough to attract cash rich, time poor customers.
The problem is that Amazon clearly intends to stomp on these businesses with its acquisition of Whole Foods and its application for a trade mark to enter this line of business.
This has decimated the valuation of Blue Apron and, we suspect, sent waves of panic through Hello Fresh.

Prior the Whole Foods announcements, Blue Apron was expecting to IPO at $15-17 per share and as of the close of trading on 17th July 2017, the shares were valued at $6.59 some 59% below where it was just a few short weeks ago. The bigger problem is that Blue Apron has massively ramped up both operating and capital spending ahead of its IPO.
In Q1 17 Blue Apron lost the same amount of money that it did in the entirety of 2016 and also spent $50m on capex which it finanaced by raising debt.
Hence, after paying off the debt, Blue Apron has around $250m in the bank which is not going to last very long with losses running at $50m per quarter. It either has to generate profit soon (unlikely) or raise more money. This is going to be extremely difficult because with the share price 59% below where it was expected to be and Amazon coming head-on, no one is going to want to finance the company.

The further problem is that Amazon new found scale in groceries will mean that it will most likely undercut Blue Apron and Hello Fresh and still offer consumers better quality produce with more reliable delivery. The one advantage that Hello Fresh has over Blue Apron is that it operates in Europe where Amazon has yet to arrive with groceries giving it time to react and that it is backed by the much larger and better financed, Rocket Internet. If Blue Apron had remained private, this issue would not be nearly so acute as one would only be able to speculate on the impact on Blue Apron’s valuation rather than see it in the cold light of day.
Hence, we can Blue Apron’ valuation continuing to fall and then being acquired, potentially by the behemoth that has been the architect of its woes. We see no bargain to be had and would steer well clear of this.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

17 July 2017

Baidu - Talking machines

The way in China is wide open for Baidu.

Baidu’s strategy around its AI platform and its Duer OS has become clearer and with the support of a large number of chip vendors, it is in pole position to be a major player in smart connected devices in China. DuerOS is not a traditional OS like Android or iOS but instead is a much more focused sub-system that is capable of bringing intelligent voice control and intelligence to any device in which it is implemented. DuerOS’s direct comparisons are the software that runs on Amazon’s family of Echo products, Google Home or JD.com’s DingDong.
While Duer still speaks no English at all, it is currently by far the leading contender in this category for China for two reasons. Firstly, ecosystem. Baidu has already lined up an impressive list of component and device manufacturers who will be implementing DuerOS in their products. Realtek, Intel, Nvidia, MediaTek, RDA, Conexant and ARM have signed up to support the system, which combined with a series of device makers, should create a pretty healthy ecosystem. There are already around 30 products in the pipeline encompassing pretty much the entire range of domestic electronic devices and appliances. Secondly,  Artificial Intelligence. Edison Research has indicated that Baidu’s AI is second only Google and certainly far better than anything else currently on offer in China. This is a product of years of work as well as having developed by far the leading search function in China. The net result is that DuerOS, like Google Assistant, should be able to provide users with the best experience when it comes to understanding and dealing with voice based requests. Putting these two together put Baidu in pole position when it comes to creating an ecosystem within which a whole series of devices can talk and understand both the user and each other as well as work together. This represents a big threat for Xiaomi which has laso built quite a large ecosystem of smart devices but they really lack the intelligence that DuerOS can offer.

The upside for Baidu is that by powering all of these voice-enabled gadgets, it will be able to gather data about its users that it will be able to make its search all the more relevant.
One of the big differences between China and Western markets is that no one seems to care very much about privacy meaning that this strategy could work very well. We do not expect Baidu powered machines to suddenly start spewing out voice-based advertising but learning what its users like and what their needs are will help it make its search results more accurate and hence more valuable to advertisers. Baidu is still the search leader in China but its recent problems with fake advertising are only just behind it and this could provide a good pillar for long term growth. Its real rivals, Alibaba, Xiaomi and Tencent, are miles behind when it comes to AI and voice-based services, leaving the Chinese market wide open for Baidu.
This combined with its leadership position in AI and search are the main reasons why we still like Baidu together with Tencent and Microsoft.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

14 July 2017

Uber and Yandex - Russia on top

Uber bails from another fight it was not going to win

Yandex and Uber are merging their ride hailing businesses in Russia and surrounding countries but it is clear to me that the real winner here is Yandex that has managed to send Uber home with its tail between its legs. Yandex and Uber have announced that they will create a new company and contribute both cash and their assets to create a company that will offer ride-hailing and associated services (like food delivery) in Russia, Kazakhstan, Azerbaijan, Armenia, Belarus and Georgia.
Yandex is contributing $100m while Uber is putting $225 into the new company. Critically, Yandex will own 59.3% of the new company while Uber will own 36.6% with the employees holding 4.1%. The CEO of Yandex. Taxi will become CEO of the new company and we have no doubt that all of the key operational roles will be filled by executives from Yandex.Taxi.
The new company has an agreed valuation of $3.73bn after the transaction.

The fact that Yandex has ended up with 59% of the company and outright control despite only putting in less than half the money that Uber has put in, indicates that its existing ride hailing business is far stronger than Uber’s. We see this is an almost exact repeat of what happened in China when Uber sold out to Didi and withdrew from the country. Uber had very little choice as it was competing against the local champion and was only around half of its size. Uber and Yandex.Taxi are market places meaning that to really make money, one has to have 60% market share or be twice the size of the nearest competitor. We suspect that Yandex.Taxi was already almost at that point and that seeing the writing on the wall, Uber took the wise decision to sell out. The net result is that Uber has a 37% stake in a company that will now dominate 5 countries and should be able to show very healthy profitability.
This is a much better outcome than the alternative which was holding 100% of a money losing company and being eventually being driven out of business.

Uber is currently beset with real problems in addition to the management issues it is facing at home. Russia is the second huge market from which it has been driven which will give competitors in Brazil and India hope that they can do the same. This makes its global domination strategy look somewhat questionable, leaving its real opportunity being to take control of autonomous transportation and creating transport as a service. The problem here is that analysis of autonomous driving data strongly indicates that Uber is by far the worst at autonomous driving, casting doubts over whether it will be able to live up to that ambition. With both of these outcomes looking decidedly shaky and management turmoil, it is not a surprise that Uber investors are feeling somewhat nervous.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

14 July 2017

SoundCloud – clouds of red

Management does not have the luxury of choice.

Poor monetisation strategy and a lack of fiscal discipline is likely to ensure that SoundCloud ends up being forcibly acquired by one of its rivals when it finally runs out of money. From looking at the contenders, Google Music looks like the best fit. Despite raising $70m in debt in March 2017, the company is in dire financial straits and it was forced to close offices and lay off 40% of its workforce last week saving an estimated €16.7m.

Given that the company lost around €50m in 2016, this looks set to only prolong the stay of execution until sometime in Q4 2017. The company has said that it wants to take back control of its destiny (from its venture investors presumably) but with no money coming in and great difficulty in raising more, management does not have the luxury of choice.

The big question is the user base. SoundCloud last updated this figure 3 years ago when it said that it had 175m MaU but there is concern that the success of Spotify’s free tier and YouTube have taken a big bite out that number. This will have a material impact on any potential acquisition later in the year, but for the moment the main concern remains cash flow or the lack thereof.

We see two problems: monetisation and fiscal discipline.

Monetisation: Assuming that SoundCloud still has 175m users, it is currently generating $0.02 per user per month in revenues. This compares very poorly to Spotify which we estimate generates $2.54 per user per month despite the majority of its users being on its free tier. The fact that Spotify is 127x better at monetising its users than SoundCloud is, more than accounts for differences in catalogue and user base and shines the light squarely on SoundCloud’s lack of execution. Anecdotally, as a regular SoundCloud listener on its free tier, I have never heard or seen a single advertisement, further reinforcing my opinion on execution.

Fiscal discipline: SoundCloud has had nice offices in Berlin and elsewhere, has offered free catered lunches twice a week and gifted new employees MacBooks and headphones as well as other freebies. What is more, management has had its head in the sand with regard to the financial car crash that has brought it to its current predicament which potentially could have been avoided if it had been faced head-on. The net result of the sudden layoffs is that morale has come crashing down and I understand that the people that SoundCloud badly needs to keep if it is to fix its monetisation problem, are now looking to leave. The biggest problem is that the financial problems will absorb much of management’s time in trying to raise more money, meaning that the real problems of the business go unaddressed.

Consequently, the company will run out of money in Q4 17, as predicted, and be forcibly acquired for just enough to pay down the debt ($70m) leaving the assets unencumbered. Of all the potential suitors, Google makes the most sense because SoundCloud is most like YouTube as a repository of user generated content and in that regard, Google will probably be most able to monetise what SoundCloud cannot. We can see it being slotted into the YouTube infrastructure and being rebranded YouTube Audio or something similar.

The future is very bleak for SoundCloud but I think that management has only itself to blame for spending too much time feathering its nest and not enough time on grinding out hard cold cash.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

14 July 2017

China Internet – Home court advantage

Regulatory enforcement makes life even harder for the foreigners

China appears to be on a path to plugging the leaks in the Golden Shield Project (aka The Great Firewall of China (GFW)) which is likely diminish to almost zero the small presence that Google, Facebook and so on have managed to establish to date. Regulation in China can be a very grey area but when it comes to The Great Firewall of China, the government appears to be deadly serious about enforcing the rules it announced in January 2017. In January the Ministry of Industry and Information Technology (MIIT) announced that all special cable and VPN services need to obtain government approval to operate. This news past without too much fuss as many services such as ride hailing have continued to operate despite being technically illegal. However, over the last few days the MIIT has clamped down further by adding another 84 categories of content to the blocked list as well as demanding that ISPs prevent users from using VPNs by February 2018. That it is the demand that ISPs prevent users from using VPNs that has the scope to have the greatest impact.

There are two factors to consider. Firstly, there are many VPN providers that are capable of circumventing the GFW but do not have a physical presence in China. Hence, they will be unaffected by the regulation or its enforcement by MIIT. Secondly, it is much easier to block the vast majority of VPN traffic than most users think. There are two main protocols in use: L2TP/IPsec and Open VPN. Of the two, L2TP/IPsec is used far more because this protocol has been natively implemented into Windows 10, MacOS, iOS and Android which between them account for almost all internet traffic globally. However, L2TP/IPsec has a problem which is that while the traffic is encrypted using IPsec, it is always transmitted on port 500 making it very easy to identify. Open VPN is much more complicated to set up and use but it can be configured to run over almost any port, making it very difficult to detect. Because most users are not technically literate, they tend to use L2TP/IPsec and any ISP determined to block this simply has to block all encrypted traffic on port 500 to shut it down completely. This will leave Open VPN as the only viable option in China and because of the greater complexity in using it, only the very determined users will put the required effort in to get it working. This will further hamper the efforts of the foreign ecosystems to gain a foothold in the domestic Chinese market.

However, the flip side is that it will make the entrenched positions of Baidu, Alibaba and Tencent all the more secure as increasingly, they only have to worry about each other.
The net result is that our preference for Tencent increases as its position at home will become more secure even as the international market remains wide open for it to address.
This is why, it remains our favourite ecosystem from an investment perspective.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

10 July 2017

Xiaomi - Back in black

Xiaomi is back but ecosystem nowhere to be found.

A monster quarter has brought Xiaomi back into contention as a major player in the smartphone industry but this recovery needs to be more than just a product cycle for it to stay there.
In a letter to employees, CEO Lei Jun has announced that Xiaomi has shipped 23.16m smartphones in Q2, up 70% QoQ. Most importantly, this represents a significant gain in market share from 3.6% in Q1 2017 to as much as 6% in Q2 2017. This looks to have been achieved through a combination of factors. Firstly, new products. The new flagship Mi 6 launched at the beginning of the quarter which was well received and looks to have been the backbone of the recovery. Secondly, retail channel. We have long been of the opinion that Xiaomi ground to halt because it had fully exhausted the capacity of selling devices over the internet. In order to address a wider slice of the market, Xiaomi has invested heavily in retail with 123 MI stores opened across China and the first results from this push are now being seen in the numbers. Thirdly, India and overseas. Investments in India are beginning to pay off with the Redmi Note 4 becoming the biggest volume smartphone in Q2 17, elevating Xiaomi to No. 2 in India. By far the largest part of Xiaomi’s overseas fan base is to be found in India and this should help the fan base to grow further. However, India can be one of the most fickle markets as it is so price driven and as many Indian brands have found, success can be all too brief.

This quarter will mean that its revenue target of RMB100bn in 2017 should be reasonably easy to achieve but the company also set itself the target to ship 100m smartphones in 2018.
This is achievable as long as the company can hold onto the share that it has so suddenly won back. This is the big question as if most the volume is coming as a result of its nice new products or very generous pricing (India), then this is unlikely to be sustainable. This will result in a few very strong quarters as its fan base upgrades and then a drift back to baseline.
Xiaomi has a chance to avoid this with its growth outside of China and its push into retail but it will cost it dearly in profitability. This is because amongst all of this success there is no mention of its ecosystem anywhere. This leads us to believe that Xiaomi is still selling its products pretty much on the basis of good quality hardware at very attractive prices.
Only by luring users in and having them identify with Xiaomi software and services can Xiaomi ever really hope to make than a commodity margin in smartphones.

Hence Xiaomi, like all of its Android brethren (except Samsung) is making 2-4% EBIT margins in the best instance. This means that even hanging onto this level of market share in the long term would see EBIT generation of around $1.5bn per year. This is not nearly enough to justify anything like the $45bn at which it last raised money, but it is enough for Xiaomi to remain independent. The risk of being acquired by Tencent or Alibaba will decrease, should this new level of market share prove to be sustainable.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

7 July 2017 · 2 min read

Samsung Q2 17 – Just chipper

A truly mighty performance from Samsung puts it well on track to promoted to being the largest semiconductor company in the world by revenues this year

Samsung heading for No. 1. A truly mighty performance from Samsung puts it well on track to promoted to being the largest semiconductor company in the world by revenues this year.

Samsung has reported preliminary results for Q2 17 with revenues / EBIT expected at KRW 60tn / KRW 14tn nicely ahead of consensus of KRW 58.4tn / KRW 13.0tn respectively.
As always with Samsung, the market has already taken into account the discrepancy between published expectations and the real figures, resulting in no meaning movement in the shares after the announcement. Despite the recovery of the handset business following the Note 7 disaster, these results are primarily driven by semiconductors where Samsung is extending its dominance while its competitors flounder. The difficulties that Toshiba is going through and the uncertainty surrounding the future of its flash memory business has certainly done Samsung no harm so far this year. This combined with a rapid move away from magnetic hard drives to solid state storage has meant that demand has been so strong that both volumes are growing very quickly and price declines have slowed.

Around 50% (if not more) of EBIT has been derived from the semiconductor business while the handset business has remained solid but much more pedestrian. The outlook remains very strong as the smartphone market is seeing a temporary blip in growth while the trend towards solid state storage looks set to continue for some time to come. Consequently, it looks pretty certain that the next two quarters are likely to see Samsung post two more record levels of profit and cash generation.

However, this has been widely flagged already and with the shares at KRW2.4m, the valuation argument for holding a big position it not nearly as great as it was. Consequently, we remain pretty ambivalent to Samsung, preferring Tencent, Baidu and Microsoft.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

5 July 2017

Samsung Bixby - Old demon

The software / AI demon remains un-exorcised

Samsung is continuing to dominate hardware but once again its shortcomings in software and particularly artificial intelligence (AI) are laid bare for all to see. In March, Samsung launched the excellent Galaxy s8 and with it a personal assistant called Bixby that was supposed to be able to make using the device even more fun, easy and intuitive. Unfortunately, the promised complete, contextually aware assistant with best in class natural language recognition has turned out to be a vaguely relevant page of content that only speaks Korean.

The English-speaking version of Bixby was first promised at the end of May, was then pushed to June and now seems to be on hold indefinitely. The problem now is that Samsung is unable to get hold of enough data in English in order to train Bixby well enough to offer a decent voice recognition experience. To me this makes no sense and speaks to discord and poor communication between the different parts of Samsung working in this area.

Firstly, Samsung purchased Viv Labs in 2016 which demonstrated a first-rate natural language recognition system in its personal digital assistant. If the Viv Labs offering is so good, why is Samsung not using it to fix the English language recognition problem that it is having with Bixby? Instead, Viv seems to be inexplicably gathering dust on a shelf until Bixby is ready for the two to be put together. This increases my suspicion that Viv Labs was in fact the last turkey in the shop and that in reality its system does not work nearly as well as had been promised when it was demonstrated.

Secondly, Accurate speech to text is now table stakes in voice recognition and there are a large number of commercial solutions available for implementation. The fact that Samsung is struggling to get this part right as an indication of how far adrift it is. The beta testers who have used it have very mixed opinions on it but perhaps the most telling is that no one is saying that it is better than Google Assistant. The bigger problem is that Bixby is not alone on the Galaxy s8 as Google Assistant is sitting on the home key where it is generating far more usage and most importantly collecting a large proportion of the data the device is generating.

Bixby is suffering from the classic chicken and egg problem which all Digital Assistants have. This is that to improve they need to be used, but to be used, they need to be useful in the first place. The reason why Bixby has no idea of one’s preferences or one’s history is because Google is so much better than Bixby that one will always prefer to use Google.
This is where Bixby is going to fail because it will not be able to generate the usage that it needs to even have a chance of catching up with Alexa, Siri and Cortana, let alone Google Assistant.

Furthermore, relationships and co-working are once again becoming strained inside Samsung just as they were in 2013, when Samsung tried to create its own digital ecosystem.
The net result is likely to be a product that never really works leaving Google as the dominant provider of services on Android devices. Samsung remains a dominant power house in Android smartphones, TVs and semiconductors but when it comes to software, it simply cannot shake its old demons. Hence, we see Samsung continuing as a hardware company which makes money by selling commoditised products in such big volumes that it can make a very healthy profit. On that basis, we continue to be ambivalent to the shares as the strong rally they have enjoyed since the company put the Note 7 disaster behind it, has exhausted the valuation argument. We prefer Tencent, Baidu and Microsoft.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

3 July 2017

LeEco - Bleeding out

LeEco could be acquired by one of the BATmen

Despite closing the vast majority of its US operations, LeEco’s troubles are far from over as its cash problems have intensified which could lead to its eventual acquisition. Leishi Internet Information & Technology (listed parent of LeEco) held its AGM last week and admitted that the cash crunch that first appeared towards the end of 2016, is now far worse than expected. LeEco raised $2.2bn in January from Sunac but instead of using the money to fix its financial problems and invest in its fledgling businesses, Leishi used it to pay down debt. Some of the debt was in the founder’s (Yueting Jia) name which may explain why debt was paid down rather than being used to keep its subsidiaries going.

The result was that all of the operations (especially USA and Faraday Future appear to have received no cash injections at all, leaving them in dire straits. This is why the company has had to exit its acquisition of Vizio, sell the land in Silicon Valley it bought from Yahoo, close most of the US business and the founder has also been forced to sell his stake in electric car company Lucid Motors. Yueting Jia also admitted at the AGM what we have long suspected which is that the real problems have been caused by LeEco’s automotive ambitions, Faraday Future. The company is now seeking funding for this venture but given that many participants in the automotive industry and the state of Nevada (where the factory is being built) have grave doubts with regard to its viability, raising money will be extremely difficult.

Consequently, we see two outcomes for LeEco. Firstly, it sells or closes all of its automotive operations and pours everything into its core business as a provider of Chinese media over the Internet. This would mean a return to its more humble origins and not something that I think its founder has seriously considered. Secondly, it continues trying to create an ecosystem around televisions, mobile phones and cars for which it is very unlikely to see any success. We do not think that Leishi has the capital, management depth or credibility to bring this ambition to fruition meaning that we see an intensification of the cash crunch if this option is chosen. Given management’s commentary at its AGM, we suspect that it is going to go for option 2 which will end in failure. This is likely to cause the real value of the shares (currently suspended since April 2017) to continue their free fall.
This would make the Internet media asset a good tuck in acquisition for Baidu, Alibaba or Tencent (BATmen) all of whom are aggressively vying to become the leader in the Digital Life segment of Media Consumption in China.
In the absence of real fiscal discipline, we fear that this will be the ignominious fate of a once great ambition.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

30 June 2017

Digital sensors – Eyes and ears

Data is the raw material of artificial intelligence meaning that will be increasingly critical that the sensors that collect that data are reliable and accurate…sensors will remain an area of intense investment and an area where we would want to be invested

Sensors are the eyes and ears of AI. Data is the raw material of artificial intelligence 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 we 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.

There are two ways in which the data that these sensors generate can be improved, firstly, 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, we 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.

Secondly, 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. 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, 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. This is crucial as sensors are the eyes and ears of the machines upon which the world increasingly depends. Consequently, sensors will remain an area of intense investment and an area where we 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.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

28 June 2017

Alphabet - Timeslip

Google has time on its side in Android.

. 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. We 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 we are 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, 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 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 that while the MADA is entirely voluntary technically, it is effectively mandatory because there will be no meaningful handset sales without it. We 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, 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, we still find it to be unattractive preferring instead, Tencent, Microsoft and Baidu.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

28 June 2017

Etsy - Red Flags

Etsy serves as a warning to Uber

The struggles of e-commerce player Etsy is yet another sign how important it is for a network business to have either 60% share or be double the size of its next competitor. This should serve as a warning to Uber.

Etsy is an e-commerce market place (like Alibaba) that specialises in the selling arts and crafts products made by small artisan producers. It is a 3P e-commerce provider in that it simply serves as a market place rather than Amazon which mostly runs its own inventory and makes a retail margin. To make money, Etsy charges sellers to be on its platform and also sells them services to make the process of selling their products simple and easy. Etsy is often described as “the handcrafter’s Amazon.com” and it is here where its real problem lies.

In October 2015, Amazon launched Handmade at Amazon and in doing so became a direct and brutal competitor of Etsy. Although Etsy remains the leader in the small niche of handmade artisan goods, it simply has no chance of competing against Amazon. Amazon can use its scale to put real pressure on pricing at Etsy and this has been felt with a real downturn in Etsy’s financial performance. Etsy has reacted by cutting 21% of its workforce and focusing on areas where it thinks that it can compete. These include improved search functionality as well as smoothing the buying process to ensure the highest possible conversion rate. However, cuts are being made across the board including both R&D and Marketing implying that Etsy has had to make some hard choices. The essential problem is that many users who buy handcrafts also buy products on Amazon, meaning that its easier for them just to stay where they are rather than go somewhere else. This means that Amazon can continue to turn the screws on Etsy and Etsy merchants are likely to have to migrate to Amazon as this is where they will find most buyers. Etsy has failed to maintain its place as the go to place to buy and sell handmade artisan products as it has been unable to keep Amazon out of its niche despite having been there for many years. The result is likely to be that the current cuts will have a negative impact on revenues, necessitating further cuts and so on.

Etsy will be unable to survive in its own and is likely to end up being forced to sell itself at a valuation far less than the market is pricing in today. Network based businesses are an all or nothing market where if one is a niche player, one must defend that niche at all costs. As long as one remains the go to place to transact with more than 60% share or double the nearest competitor, a good return will be earned. However, the minute that is hallowed status is broken, with a much larger player getting some traction in that niche, then the game is over.

This should serve as a red flag to Uber. Uber is vulnerable right now as the current turmoil has allowed Lyft to make up some ground in its home market of USA. Uber cannot afford to let Lyft get to close to half its size otherwise it will be at risk of losing that “go to” status signalling a bloodbath in its home market. Uber still has time to act, but for Etsy, the game is over. While there may be bargains to be had on its site, the share price is certainly not one of them.”

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

21 June 2017

Snap Inc. - Snap in the box

Facebook keeps Snap Inc. in its box.

Despite launching in August 2016, Instagram Stories has been extremely successful in mitigating the threat from Snap Inc. as it already has 50% more users than Snapchat. In a blog detailing some feature updates, Facebook has disclosed that Instagram Stories now has over 250m daily active users (DaU) all of whom have been added in the last 10 months. By comparison Snap Inc reported 166m DaU at its Q1 results in May and a far more pedestrian level of user growth. This is a strong indication that Facebook has been very successful in preventing its users from going outside its fledgling ecosystem of apps by replicating new services in house. It is also a sign of how critical the network effect is as Facebook’s 2bn users can all be directed to the Instagram app, use the same credentials and get going with a minimum amount of fuss.

By contrast, Snapchat is a completely different system to which users have to be separately recruited. It is this ease of transition and the fact that it is quite simple to cross promote Instagram Stories that has allowed Facebook to imitate an innovation and quickly dwarf the original creator. This is extremely concerning because we suspect that Facebook has more than 90% penetration of the smartphone users that matter from a marketing perspective. If this avenue in increasingly closed off to Snap Inc., then very real questions need to be asked about its medium-term growth prospects.

Snap’s narrow focus on Instant Messaging begs the comparison to Twitter, but this comparison does not go far enough. Twitter is stuck in a niche that it has fully monetised and its attempts to branch out into video are faltering. This means that its outlook for growth remains very bleak. However, in the Digital Life Pie segment of microblogging and related messaging, where Twitter is present it is dominant with no opposition. This means that once it stops spending money in trying to grow, it should make good, but static returns from monetising that niche.

Snap Inc on the other hand still has some growth ahead of it but Facebook is doing a very good job of keeping it out of its core user base. The company could conceivably generate revenues of $800m in 2017E and $1.2bn in 2018E as it is quite far from fully monetising the users and traffic that it already has. However, this is not enough to justify the current valuation.
Assuming that all goes well for the next 18 months, we can still be comfortable with a valuation of $14.4bn. While the current valuation is now closer to this figure than it was a few months ago, at $17 a share Snap Inc is still 13% above what would be considered to be fair value.
Consequently, we still see no reason to get involved especially as Facebook is showing every sign of very successfully keeping Snap in its box. Twitter, for all of its faults, still has better prospects.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

20 June 2017

Digital Car - Sitting ducks pt. II

The best infotainment unit is the one in the pocket

A car maker with a future is a car maker that realises how vital its data is and pays the buyers of its vehicles for the right to use it. This also has the added benefit of creating a relationship with the buyer of the vehicle which is something car companies have not really bothered with to date. The latest survey from IHS examines the technology that consumers are and are not willing to pay for when they buy a new vehicle.

The data shows that consumers across the world are most willing to pay for a sunroof and rear seat entertainment systems with things like telematics and in-car Wi-Fi trailing significantly.
The survey also revealed that consumers expect technology in vehicles to evolve as quickly as it does in mobile devices. This creates an enormous problem for an industry with a 4 to 5 year design cycle where even the top end infotainment systems costing thousands of dollars are using hardware that is 5 years out of date. The result is that they can be outperformed by a $150 Android device. This means that the user is likely to have a better digital experience in a top of the range vehicle with a cheap smartphone rather than with the infotainment unit.

This strongly encourages the user to access his Digital Life with a smartphone in the vehicle rather than to use the infotainment unit. This is the last thing every car maker needs.
Users still buy cars based on performance, form factor, safety and economy but increasingly digital services will play a part in the user’s decision of which car they buy. If the infotainment unit is not being used and everything is being done on a smartphone then the digital battle will have already been lost and cars will have moved closer to being commodities.

Furthermore, the automotive industry has its strategy with regard to telematics completely back to front. Instead of forcing users to pay for telematics, they should be giving users a discount or free services for agreeing to grant access to the data that these systems generate. Using digital ecosystems as a benchmark, car companies could give users meaningful discounts on the price of the vehicle and still end up with higher revenues and margins. This is because the data that these vehicles generate could be very valuable to other companies who provide services based on collecting data. For example, using cars as weather or traffic probes would cut down on the need to install expensive infrastructure.

However, to be valuable, all cars need to be generating this data and while car makers continue to charge users for this feature, penetration will remain low leaving the door open for disruptors. One only has to delve very briefly into the world of start-ups to see this disruption coming. For example, many start-ups are providing their automotive related digital services on smartphones and not infotainment units and there is significant development of technology that could by-pass the car companies entirely. For example, a quick tour of the automotive section of a technology trade show revealed two companies that use vibration to work out exactly what is happening within the vehicle rather than use the traditional sensors. One of these claimed that it could, using 10 vibration sensors on a helicopter, completely replace the 160 sensors currently being used. This data could easily be relayed to a smartphone app and cut the car companies out from the only data source which remains proprietary to them.

We found these start-ups on the stands of the very companies which they intend to disrupt, further reinforcing our opinion that most of the automotive industry still has its head in the sand. Instead automakers should be aggressively moving to obviate the reason to be bypassed by making their infotainment units and sensor data easy to use and readily available with simple APIs. While, this reality persists, the automotive industry remains a sitting duck for the ecosystem companies who have long understood the value of that which the car industry seems to ignore.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

19 June 2017

Facebook - Soft target

Facebook chasing broadcast rather than Netflix or YouTube.

Facebook’s move into Media Consumption is well underway but it looks to us to be going after broadcast rather than premium or user-generated content.

Facebook has closed a deal for a reality TV show called Last State Standing and is close to doing a deal to shoot and air a second season of Loosely Exactly Nicole which originally aired on MTV. It is also commissioning shorter shows from the likes of Vox Media and Buzzfeed. This is in no way a move to compete with the high-end shows on Netflix or the user generated content on YouTube but instead looks like it is aiming at broadcast. Despite the atmosphere of cord cutting, broadcast TV is still an advertising market that is worth $70bn a year and it is the younger end of this market that Facebook is targeting. This looks to be somewhat experimental as Facebook is not really targeting expensive, high quality content as one of the shows it is looking at was cancelled after one season on MTV and has an IMDB rating of just 5.1. These shows will air first on Facebook via a video tab called Spotlight that will be present at the side of the screen and will be funded by advertising. The broadcast market represents a much softer target in our opinion as Facebook can add all sorts of interactive and social functionality on top to make the experience much more engaging than just watching TV. The level of investment being made at the moment is small with a few hundred thousand dollars being spent per episode on its big shows as well as a few tens of thousands being spent for shorter segments from producers like Vox Media.

We see this as a sign of Facebook’s media consumption strategy reaching the point where it can be considered to be properly present in this segment of Digital Life. This will bring its coverage of Digital Life to 46% up from 36% where it is today. This represents a 28% increase in its addressable market which should allow revenue growth to re-accelerate after the slowdown I have been long expecting this year. Given that Spotlight is not yet available in the app and that Facebook is just closing the deals to produce this content now, we do not expect these shows to hit Facebook until 2018. Consequently, for 2017, we see Facebook’s growth potential remaining hampered by the fact that it has already fully monetised the segments of Digital Life where it is already present. The result is likely to be a much slower growth profile, which is something that the market has still not fully anticipated.

Hence, we can see disappointments coming in the Q2 17 and Q3 17 results as the market adjusts to this more sanguine short-term outlook. It is at the point we would be looking to go back into Facebook as 2018 could see an uplift in financial performance driven by monetisation coming from Media Consumption. This should be followed up by Facebook’s expansion into Gaming and Search which would bring its coverage up to 78% and global market leadership, pipping Tencent which is currently on 77%. This is what underpins our long term positive view on Facebook, although we are expecting weakness in the short-term as it will be sometime before the new business lines can pick up the mantle of growth.
In the meantime, we prefer Tencent, Microsoft or Baidu.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

16 June 2017

Tencent - Feathering the nest

If it was to effectively monetise its ecosystem at home and aggressively push into developed markets, it could become one of the biggest digital ecosystems globally.

Tencent – Feathering the nest. Rovio could help Tencent spread its wings. Rovio is almost certainly past its prime but it has an asset that could be capitalised on should the right buyer come along. Tencent is not showing any real signs of being the right buyer at the moment but its ownership of Supercell makes Rovio a good strategic fit. Rovio is the creator of the well-known Angry Birds franchise where its revenue from games has been revitalised by the recent good performance of the Angry Birds movie. 2016 revenue / EBIT was Euro190m / Euro17.1m with a bump in games, thanks to the movie, bringing the company back into profit. The revenues from the movie will be recognised over the 2017 and 2018 financial years.
Tencent has had some success in taking Western games and leveraging them into China as League of Legends has become a major hit in China through Tencent’s patronage. We have been fairly disappointed with Tencent’s acquisition of Supercell so far as while it is now able to leverage Supercell’s hugely popular games into China, the real opportunity lies outside.
The Chinese market is starting to slow meaning that the BATmen will need to look elsewhere long-term for sources of growth. Of all of the BATmen, Tencent has the greatest opportunity as the Digital Life segment in China within which it is the strongest remains unoccupied in developed markets. This is largely because the big multiplayer gaming communities Xbox Live, PlayStation Network, Valve have all failed to leverage their communities from PCs and consoles into mobile. Activision Blizzard, which purchased King Digital exactly for this purpose, is also not doing a great job of it as active users of King mobile assets have gone into freefall.
This leaves the way open for Tencent to begin to build its assault on developed markets starting with the all-important segment of Gaming which it dominates at home. However, it has not shown much intent to make the most of this opportunity instead concentrating on leveraging overseas games into its home market. In Supercell it considers itself to be a financial investor which is why it seems to have been left pretty much to its own devices. Rovio would be a good fit for Tencent alongside Supercell but the real opportunity lies in using these assets to grow its presence overseas. Tencent has by far the strongest ecosystem in China with 77% coverage of the Chinese Digital Life pie which is why there is so much upside.
It makes almost all of its money from selling media and games with only a small proportion coming from monetisation of the ecosystem it has created.
If it was to effectively monetise its ecosystem at home and aggressively push into developed markets, it could become one of the biggest digital ecosystems globally.
However, there is still a long way to go in recognising this opportunity and it needs to structure its assets appropriately to take advantage of that.
Consequently, we don’t see Tencent seeing the benefit of this for some time to come but the good news is that there is still enough growth left at home to sustain the valuation for a while.
Tencent, alongside Baidu and Microsoft are our favourite ecosystems at the moment.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

14 June 2017

Facebook - Dial M pt II

Very little AI in the assistant that has launched.

Now that Facebook’s digital assistant is available in the wild, one can see how simplistic it is indicating just how far Facebook still has to go to get a real grip on making its services more intelligent. Facebook M has been in beta for over 18 months and has comprised of a combination of automated responses and human interactions where the vast majority of the tasks have been carried out by humans. The problem with using humans of Digital Life services is that it is very expensive to scale the service for 2bn users especially when the service will be funded by advertising. This why Facebook is working as quickly as it can to develop its in house expertise and while it remains a laggard in AI, it has shown some progress.
For example, at its developer conference, it showed some good progress on machine vision enabling its apps to recognise the world they can see through the smartphone camera.
It also made Facebook M available to US users and most recently in Spanish to users in Mexico and US.

However, what has gone live is only a small part of the grand plans that were announced in 2015 which had an always on, all knowing bot with which the user could do almost anything. Instead, Facebook M is limited to suggestions referred to as “M suggestions” which are contextually sensitive pop ups that appear in messenger when the user types messages.
For example, hello (or hola) results in the suggestion of emoticons that are waving or “tomorrow” can result in the suggestion of a link to the calendar to create an appointment.
The available functions are very limited leading to believe that each function has been manually programmed using statistical analysis meaning that there is virtually no AI in the service that has launched. Although, the service is extremely limited at present, Facebook has created a placeholder ready to be upgraded when its ready, as well the possibility to generate some data that should help improve what is already there. Most of the AI we can see in Facebook is in machine vision where Facebook demonstrated some progress at F8.
However, outside of mixed reality, the immediate applications for this in Facebook’s ecosystem remain quite limited.

This reinforces my opinion that Facebook is way behind when it comes to AI and that the biggest challenge it faces is to bring its AI into line with that of its main rivals. The problem is that its rivals are starting to use AI to improve the depth, richness and utility of their services potentially leaving Facebook behind. To keep up, Facebook currently throws humans at its AI related problems (eg fake news and objectionable content) which is clearly not scalable. Unless the AI problem is fixed, Facebook will have to employ more and more humans leaving its EBIT margins, valuation and competitiveness at risk. Facebook has some time to address this problem as its newer Digital Life services of Gaming and Media Consumption have scope to keep revenue growth going in the medium term.
This is why we like Facebook’s investment potential but are waiting for the short-term fall in revenue growth to be priced in.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

14 June 2017

Facebook - Dial M pt II

Very little AI in the assistant that has launched.

Very little AI in the assistant that has launched. Now that Facebook’s digital assistant is available in the wild, one can see how simplistic it is indicating just how far Facebook still has to go to get a real grip on making its services more intelligent. Facebook M has been in beta for over 18 months and has comprised of a combination of automated responses and human interactions where the vast majority of the tasks have been carried out by humans. The problem with using humans of Digital Life services is that it is very expensive to scale the service for 2bn users especially when the service will be funded by advertising. This why Facebook is working as quickly as it can to develop its in house expertise and while it remains a laggard in AI, it has shown some progress.
For example, at its developer conference, it showed some good progress on machine vision enabling its apps to recognise the world they can see through the smartphone camera.
It also made Facebook M available to US users and most recently in Spanish to users in Mexico and US.

However, what has gone live is only a small part of the grand plans that were announced in 2015 which had an always on, all knowing bot with which the user could do almost anything. Instead, Facebook M is limited to suggestions referred to as “M suggestions” which are contextually sensitive pop ups that appear in messenger when the user types messages.
For example, hello (or hola) results in the suggestion of emoticons that are waving or “tomorrow” can result in the suggestion of a link to the calendar to create an appointment.
The available functions are very limited leading to believe that each function has been manually programmed using statistical analysis meaning that there is virtually no AI in the service that has launched. Although, the service is extremely limited at present, Facebook has created a placeholder ready to be upgraded when its ready, as well the possibility to generate some data that should help improve what is already there. Most of the AI we can see in Facebook is in machine vision where Facebook demonstrated some progress at F8.
However, outside of mixed reality, the immediate applications for this in Facebook’s ecosystem remain quite limited.

This reinforces my opinion that Facebook is way behind when it comes to AI and that the biggest challenge it faces is to bring its AI into line with that of its main rivals. The problem is that its rivals are starting to use AI to improve the depth, richness and utility of their services potentially leaving Facebook behind. To keep up, Facebook currently throws humans at its AI related problems (eg fake news and objectionable content) which is clearly not scalable. Unless the AI problem is fixed, Facebook will have to employ more and more humans leaving its EBIT margins, valuation and competitiveness at risk. Facebook has some time to address this problem as its newer Digital Life services of Gaming and Media Consumption have scope to keep revenue growth going in the medium term.
This is why we like Facebook’s investment potential but are waiting for the short-term fall in revenue growth to be priced in.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

13 June 2017

E3 2017 - Glaring Omission

Very little interest in mobile gaming at E3

E3 is the biggest trade show for the computer games industry but it still seems to be ignoring one of its most important segments: gaming on mobile devices.
Mobile gaming is radically different from gaming on PCs and consoles in three ways. Firstly, PC and console games are much more expensive and more complex. Secondly they require high-end PCs or dedicated hardware to run optimally compared to mobile games which run well on most smartphones. Thirdly, they are played for long periods of time whereas mobile games are played for a series of short periods. This means that the software and hardware required to address this segment is completely different but that does not mean that there is no opportunity for the PC and console players in mobile. This is because the hundreds of millions of users who play PC and console games also play games on their mobile phones. These are different games, played in a different way with a different monetisation system but because the players are the same we see no reason why the big game communities should not be leveraged into mobile.

Sony, Microsoft and Valve have all spectacularly failed to leverage the multiplayer communities that they have on PCs and consoles onto mobile phones. This is why the Digital Life segment of Gaming in mobile remains almost completely unoccupied. This is very different to China where mobile gaming is dominated by Tencent with NetEase coming a distant second. Hence, because Gaming is the single largest segment of Digital Life (30%), there is a big opportunity being left on the table. This is the rationale for why Microsoft should be prepared to sell Xbox if the right offer comes along.

Someone with the ability to do with Xbox what Microsoft cannot should be willing to pay more for the asset than it is worth to Microsoft.
It is under these circumstances we advocate its sale as it would generate more value for shareholders than remaining inside Microsoft. The same could be said for PlayStation but because it is such an important part of Sony, we seriously doubt that it would sell under any circumstances.

The same cannot be said for Microsoft which is continuing to do very well in dominating the Digital Work ecosystem but is letting its consumer ecosystem fade away. Activision Blizzard looked to be making move on mobile gaming with its acquisition of King Digital but unfortunately, the mobile user numbers for King Digital have fallen by around 35% since the acquisition.
Hence, this segment remains wide open creating a big opportunity for someone who has the skill and determination to do in mobile what Microsoft and Sony clearly do not.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

12 June 2017

ARM vs. Intel - Pause for thought

Intel shoots at Asia rather than at home.

. With another attempt to replace Intel chips in PCs on the cards, Intel has moved to protect its position with a not so subtle reminder that its instruction set is covered by a large number of patents. The 40th anniversary of the x86 processor is approaching and to celebrate, Intel has published an editorial extolling the innovation that has made x86 by far the dominant processor in both PCs and servers. The problem has always been that the x86 was never designed to run on battery powered devices meaning that it consumes meaningfully more power than its ARM equivalent. Consequently, there has always been a desire to allow battery powered PCs (laptops) to use the ARM processor as this would, in theory, meaningfully extend their battery life.

The first attempt to do this was Windows RT which involved adapting the Windows software to run on the ARM instruction set which failed miserably. The current effort involves an emulator which takes the ARM instruction set and translates it into x86 so that the regular Windows software and applications can run with no modification. However, this proposition already has question marks around implementation and performance and now Intel is muddying the waters further with its patent pool. Intel has filed around 1,600 patents (533 families) on its x86 instruction set of which around 1,000 (333 families) we estimate are still enforceable. It seems pretty likely that an emulator that makes use of the x86 instruction set will infringe these patents and hence would need a licence from Intel to operate.

There are two reasons why this warning is not aimed Qualcomm and Microsoft but rather others who may be considering taking a similar route. Firstly, Qualcomm knows and understands more about IP licencing than almost anybody and consequently it will have foreseen this issue. Hence, together with Microsoft, it will have sorted these issues out with Intel before officially announce its progress down this route.

Secondly, in its 8th June comment, Intel states that “there have been reports that some companies may try to emulate Intel’s proprietary x86 ISA without Intel’s authorization”. At the time of writing, the co-operation between Microsoft and Qualcomm to use an emulator to get Windows running on x86 was not a report, it was an announced fact. This combined with our view that Qualcomm is likely to have sorted the IP issues out in advance, leads us to believe that this warning is targeted elsewhere. Hence, this will not impact the effort by Qualcomm and Microsoft which remains completely dependent on the implementation.

Emulators have a very bad track record in terms of consuming extra resources which to date, has rarely resulted in any real benefit accruing to the user. To succeed, these devices must perform at least as well as an Intel powered device at the same price point and have better battery life. This is the minimum requirement as without this, there is no incentive for a user or an institution to purchase the device. This is what Microsoft and Qualcomm will be most concerned about but for the other chipmakers in Asia Intel’s comments will have given them pause for thought.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

9 June 2017

Alphabet - Goodbye blue sky pt Ii

It looks like SoftBank needs to really beef up its robotics expertise if it wants to be a player in this space which is what these two acquisitions should start to accomplish.

Alphabet has reached a deal to sell both Boston Dynamics and Schaft to SoftBank leaving it more focused on its core business of collection and monetisation of Internet data. Boston Dynamics is a robotics company that specialises in robots that are autonomous as far as navigating and adjusting to their immediate environment. SoftBank is also acquiring Schaft from Google which is a humanoid robotics company that was spun out of the University of Tokyo. These robots can move around with relative ease but how they would be able generate value for Alphabet shareholders was always unclear. At the end of the day Alphabet is a data and analytics company whose objective is to categorise and understand every piece of digital information that users generate and to sell those insights to marketers. Every other piece of hardware that Alphabet makes from Google Home to Pixel and Internet Balloons, have the capacity to collect huge amounts of data and thereby generate can value to the core business.

Autonomous robots that can carry out physical tasks do not generate data about users because they are designed to replace them making them a bad fit inside Alphabet.
Furthermore, the robotics effort at Google was the brainchild of Andy Rubin and his departure, combined with the much greater focus on fiscal discipline, meant that the robots became homeless inside Alphabet. We have long believed that Boston Dynamics will be much more at home inside a company that can make use of them. Good examples of this are Amazon and Alibaba for logistics or someone like DHL or UPS.
Softbank is a good example of this but also has the benefit of a very long-term mindset when it comes to its strategy. SoftBank already produces the Pepper robot which is supposed to be able to read human emotions and help shoppers when they enter a shop or place of business. We met Pepper when wandering the halls of Mobile World Congress and CES and have to admit were not that impressed by what it was capable of. Consequently, it looks like SoftBank needs to really beef up its robotics expertise if it wants to be a player in this space which is what these two acquisitions should start to accomplish. Hence it looks like this acquisition will not be part of the $93bn Vision Fund but instead be part of SoftBank itself.
Boston Dynamics, Schaft and we suspect SoftBank’s own robotics division have been struggling to find ways to generate revenue necessitating a home with a very long-term view. That home used to be Alphabet, now it is SoftBank. The sale of these two businesses will further boost Alphabet’s short term financial performance but all of the recent fundamental improvement in Alphabet is more than discounted in the share price. Hence, we continue to prefer Tencent, Baidu and Microsoft.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

9 June 2017

The strategy around the smart home is bang on and it has created the right product

Home is where the heart is. Whilst not fans of Essential Products’ phone, the strategy around the smart home is bang on and it has created the right product. The phone simply does not do anything particularly special in a brutal commodity market and given the company’s overall strategy, we 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, it has a good chance. This is because, has been designed to explicitly address the two biggest problems with home automation that exist today.

These are firstly voice control - we have 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. 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 user 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 we 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.

We 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.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

7 June 2017

WWDC 2017 - Catch-up gems

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. The valuation case in Apple is not nearly as strong as it was 6 months ago leaving us still preferring Microsoft, Baidu and Tencent.

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 and 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. Overall, 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 however 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 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 - 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
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.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

5 June 2017

iOS vs. Android - The big switcheroo

The Digital Life pie is essential for stickiness.

Following 2½ years as an iPhone user, I have made the switch to Android and am amazed by how easy it was, switching from an iPhone to a Samsung Galaxy s8. The ease of transition came down to these factors:- Android is much better now than it was in 2014, I do not use any of Apple’s Digital Life services, and most apps are now free to download with either in app purchase, advertising or a subscription. Furthermore, most apps now store user data in the cloud meaning that switching is simply a matter of downloading the app and signing in.
Android is a breath of fresh air in that we can install anything we want with no problems. The Google Play store does not offer some apps in certain regions but this is easily fixed by downloading Aptoide which has virus-screened versions of almost everything. Furthermore, on Android anything is possible and a developer has already worked out how to re-map the Bixby hard key to Google Assistant. However, this freedom comes at a price in that many things simply do not work as well or as reliably as they do on iOS. This is mostly a result of the endemic software fragmentation that exists across Android devices which remains as bad now as it has ever been. One still has to be one’s own systems integrator. For example, the weather widget that ships as default on the home screen of the Galaxy does not work properly when it comes to updating the weather information in other cities that the user has added.
The biometric security unlocking does not work properly all the time and apps crash and quit with greater regularity compared to iPhone.
The iPhone still sets the gold standard in terms of the quality of voice calls and radio performance in areas where the signal is not optimal. Fortunately, because I am not a big voice user, this is not a huge issue. Furthermore, even though the s8 offers much better control of Bluetooth devices when more than one is connected at the same time, the iPhone offers better stability and reliability.
The main observation is that moving from Digital Life from iOS to Android was far easier than anticipated. A major reason for this is that outside of photos and videos which are a cinch to move thanks to Google Photos, I am not a user of Apple’s Digital Life services. I have never used Facetime or iMessage and as a result was not locked into the network that Apple has created around those services. This throws into sharp relief the key weakness of the iOS ecosystem which is the same now as it has always been. Apple’s position in Digital Life services is weaker than many of its peers meaning that the key selling point remains the quality of its user experience and its ability to distribute the apps and services of third parties in a fun and easy to use way. If Android close this usability and security gap to iOS, users will be less inclined to pay a substantial premium for iPhone compared to something similar running Android. This is why Apple has been working hard on things like Apple Pay, HealthKit and HomeKit but it needs to do much more before these can be considered really defensive.
Given Google’s very slow progress in taking control of its ecosystem on Android, this still gives Apple a good 3-5 years before its handset margins will come under pressure. Apple’s developer conference kicks off today where we hope to see announcements aimed at keeping Apple’s differentiation over Android. Furthermore, the iPhone 8 promises to be a worthy challenger to the excellent Galaxy s8. We have liked Apple on valuation grounds for a considerable time but following the recent increase in its valuation, it no longer offers the same value that it did. Hence, we still prefer Microsoft, Tencent and Baidu.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

2 June 2017

Samsung Bixby - Failure to launch

Bixby is not fit for purpose.

Samsung has once again delayed the roll out of the voice component of its digital assistant Bixby further reinforcing our opinion that Samsung can really only compete in hardware. This, combined with the poor performance already offered by Bixby services on the Galaxy s8, leaves me unsurprised that a method to rewire the Bixby hard key to Google Assistant has already been published.
Bixby was launched with much fanfare at the unveiling of the Galaxy s8 and promised completeness; this promises to give users complete control of enabled apps rather than the few tasks offered by other assistants. Secondly contextual awareness; Samsung is promising that Bixby will be aware of the context within which it has been triggered, making it more relevant and useful. Thirdly natural language recognition; Bixby should be able to understand complex, multi-part questions as well as prompt the user to clarify the pieces that it does not understand.

Having tested Bixby extensively, so far, the experience bears no resemblance whatsoever to these promises. Instead Bixby offers a series of suggestions of videos to watch and articles to read that bear little relevance to any interests or history. The one thing that Bixby can get right is to highlight which apps are used most but the functionality of suggesting which app we are likely to want to use next based on the time of day or circumstance is nowhere to be seen. These features are very similar to those promised by Viv, the artificial intelligence company that Samsung purchased in October 2016 which is clearly the source of this product.

However, it appears that Bixby as it exists today has nothing to do with Viv which partly explains the poor functionality but also makes me wonder why Samsung acquired it in the first place. This is a sure indicator of just how far behind Samsung is compared to everyone else when it comes to developing intelligent services. Edison research has identified three stages of voice recognition of which the first and by far the most simple is the accurate conversion of voice to text. Almost everyone, even Facebook, has pretty much cleared this hurdle but it appears that Bixby still has not. Furthermore, Bixby vision is also way behind the curve as it is unable to properly identify objects. Instead what it does is search Pinterest for other pictures with similar pixel patterns. It does not identify objects nor offer any real functionality beyond finding similar pictures rendering it useless.

Even Facebook, which we have long identified as being behind in AI, is demonstrating reasonably good machine vision which leads us to put Samsung far behind even Facebook. This leaves Samsung exactly where we left it as a manufacturer of excellent but commoditised hardware that outsells it nearest competitor by more than 2 to 1. As long as it can maintain that edge, we have no fear for its handset margins but Huawei is trying very hard to close the gap. Huawei’s disappointing handset performance in 2016 has led it to be more focused on profitability this year meaning that it will not be trying to turn the screws on Samsung with quite the same vigour. Hence, Samsung is set up to have a good 2017 but the rally in the share price has more than taken this into account. We continue to prefer Microsoft, Tencent and Baidu.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

2 June 2017

INtel vs. ARM - Silver Bullet pt. II

Implementation and performance will be everything.

. The second lap of trying to get Windows to work on ARM processors is in full swing but the key to success will be the performance of the devices.
At the Computex trade show in Taipei, ASUS, Lenovo and HP have all announced that they will be producing Windows 10 devices that are powered by Qualcomm’s Snapdragon 835. This is the final piece of the puzzle to get devices into the hands of users after Qualcomm and Microsoft announced that they would be giving Windows on ARM another try.  ASUS, Lenovo and HP will be using Qualcomm’s Snapdragon 835 to provide both the horsepower to run the device as well connectivity to ensure and always on experience. With its first attempt, Microsoft modified Windows 8 such that it would work on an ARM processor and in the process killed flexibility and backwards compatibility to legacy software. The result was a platform that was shunned by both developers and users, completely killing any hope that ARM would gain penetration in Intel’s home turf of PCs.

This time the approach is completely different as Qualcomm and Microsoft have produced an x86 emulator that fools the software into thinking that there is an x86 chip present. The net result is that any Win32 and Universal Windows Apps, will run on the device with no modifications being required by the developer. We understand UWP apps will run natively on the Snapdragon 835 but the emulator will be required for everything else. This is where the success or failure of this venture will be determined. The computing devices will lightweight, low cost with a long battery life making them ideal candidates to run Windows 10S. This device category is ideally suited for schools but for students who have their own devices, the appeal is less clear. This is because the majority of the kind of apps students will want on their PCs are not available as UWPs. Students tend not to have a lot of spare cash and therefore will rely heavily on free software which if they are using Windows 10S needs to be on the store.

Taking the top free PC software as recommended by TechRadar, 3 apps were available as UWPs compared to 10 that were not but of which, for 2 or 3 there was something similar. Google Chrome, iTunes, Google Drive or any BitTorrent clients are available as UWPs, all which are pretty important for cash strapped students. Therefore, the performance of the emulator will be critical as it will be heavily used in these devices. On bench tests, the Snapdragon 835 is perfectly capable of running Windows 10, but there is a huge difference between performance in the lab and performance in the hands of real world consumer. Furthermore, emulators always incur a performance overhead meaning that apps running via the emulator can never perform as well as those running natively.

The key questions are – firstly, how well Windows 10 will be implemented on the ASUS, HP and Lenovo hardware to ensure the Snapdragon 835 can perform to the best of its ability.
Secondly, how much performance drag will the emulator incur. The answers to these questions will only be apparent once the devices are available but it is quite easy to draw a line in the sand. To succeed, these devices must perform at least as well as an Intel powered device at the same price point and have better battery life. This is the minimum requirement as without this, there is no incentive for a user or an institution to purchase the device. Always on connectivity is not a requirement for a Windows 10 device because all of the Digital Life activities that require this kind of connectivity have long since moved to smartphones. Hence, we do not consider it to be a valid selling point of the devices. The launch of these devices is obviously a negative for Intel but it is worth remembering that every attempt to dislodge Intel to date has been a miserable failure.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

24 May 2017

We do not think that it has ever been Microsoft’s intention to take market share away from its

Microsoft gives the PC makers room to breathe. Microsoft updated its Surface Pro at an event in Shanghai but left plenty of space for its partners to innovate within the fledgling tablet-PC category.

Microsoft has followed Apple in dropping the version number from the name and the new product makes incremental improvements:

Microsoft claims that despite looking very similar, the new product has 50% more battery life than the Surface Pro 4, clocking in at 13.5 hours under optimal conditions. This will be well received by road warriors who spend a lot of time in airports and coffee shops looking for power sockets.

The new Surface Pro is fan-less in the m3 and i5 versions which is a meaningful saving both in terms of power and noise. Microsoft is very late to fan-less computing and we see it as behind the curve as there are other devices available that run the same processors but are fan-less across the whole range. We are assuming that as the i7 version also runs Intel Iris Plus Graphics 640, more heat may be generated under heavy load than the i5, necessitating the presence of a physical fan. Going fan-less is a good opportunity to reduce thickness and weight but again Microsoft does not appear to have taken this route as it is keeping the same chassis for all versions. Instead it is leaving this to other companies like Samsung, Huawei, Eve Tech and HP which has clearly been doing some work on its form factors.

A new hinge has been created to enable what Microsoft calls studio mode. This is where the device is almost horizontal but is slanted at the same angle as the workspace of an architect or illustrator. This is very similar to the use case provided by the popular but expensive all-in-one PC Microsoft launched last year called Surface Studio. Outside of these upgrades, the new Surface Pro is an incremental upgrade which leaves plenty of room for others to address this space.

We do not think that it has ever been Microsoft’s intention to take market share away from its partners but more to show them the way forward. Historically, PC makers have really been starved of form factor innovation, having outsourced almost all of its to the ODMs. However, there are signs of this coming back. A good example is HP which as seen huge improvements its form factors with the Envy line of laptops finally living up to its name. Most PC makers now offer a Surface Pro-like product which if marketed properly, still has the potential to change the nature of PC market. A tablet PC with a separate keyboard and mouse offers a more productive, healthier and more ergonomic computing experience which renders the laptop form factor obsolete. However, PC makers and the marketing departments of Intel and Microsoft have been selling laptops for 40 years which has become a very difficult habit to break.

We still believe that this has the potential to kick the PC market back to growth as old laptops are quickly replaced, but given that this is just a product cycle, it would only last for a few years. This rising tide would float all boats but we would prefer to be aboard either Microsoft or Lenovo for this ride.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

23 May 2017

LeEco - Le-trenchment

LeEco looks to return to its roots at home.

LeEco’s foray into the United States looks like it is coming to an end which combined with a major restructuring at home, probably brings to an end any realistic hope of becoming a digital ecosystem.

We understand that LeEco is about to lay off all of its employees in the US that are involved in developing, building and selling the devices and ecosystem that LeEco is offering. Those that remain are thought to be staying to look after existing customers but we suspect that most that remain will be the ones that are working on the automotive ambitions of Faraday Future.

On top of this, Jia Yueting, the mercurial founder of LeEco, is also stepping back from his position as CEO of Leshi Internet Information & Technology Corp. (LeEco’s parent) although he will remain chairman. He will be replaced by Liang Jun who has been running the content business since joining from Lenovo in 2012.

LeEco’s CFO has also been replaced with the CFO of the China business. Furthermore, it looks like all of the content related businesses will be merged into Leshi while the automotive business is spun out as a separate unit. All of this points towards a big retrenchment where LeEco will once again become a Chinese digital content company with a shareholding in an electric car company.

We think that this means that all LeEco’s activities in the US will be focused on Faraday Future which is trying to build an electric vehicle at a yet-to-be-completed factory in Nevada. At the end of the day, we think LeEco tried to do things much too quickly and did not pay enough attention to the fundamentals of creating an ecosystem.

If we take LeEco’s ecosystem as it is today it has weak coverage of the RFM Digital Life Pie as it really only covers Media Consumption. It also gets a poor score against RFM’s 8 Laws of Robotics mostly due to the fact that it has not paid enough attention to detail when it comes to the user experience. We get the impression that the software was simply ported over from the Chinese version and not enough time has been taken to adapt the user experience for the US consumer.

The devices themselves offer great value compared to competitors with an 85 inch 4K TV for $5,499 being the best deal available by quite some margin. However, it all falls to pieces when it comes to software and this is where LeEco was hoping to make its money.

We have long held the opinion that LeEco did not have the resources to create both a digital ecosystem and an electric vehicle and that it should close its automotive operation and focus on its core business. However, it appears to have gone one step further in closing its ecosystem ambitions and spinning out automotive where we suspect it will be seeking participation from other investors.

We suspect that Leshi will now return to competing in the Chinese market which is heating up with increasing levels of investment in content coming from the BATmen. Consequently, the outlook is pretty bleak as Leshi’s ability to out invest the BATmen is highly questionable especially given the troubles that it has had with expanding into the US.

We would pick Tencent as our favourite Chinese ecosystem for investment.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

22 May 2017

Softbank Vision Fund - UB40

Pressure to employ capital is the biggest risk

SoftBank has announced that the first round of its $100bn Vision fund has closed with $93bn in committed capital but the problem now is going to be how to quickly put this huge amount of money to work. At $93bn, the SoftBank Vision Fund ranks as the third largest private equity fund globally, behind KKR with $98bn and Blackstone which has $311bn in assets under management.

The investment strategy will be wide with the fund looking to target long-term investments in both private and public companies right the way across the technology sector. The one exception appears to be semiconductors but the fund will have some exposure there if it takes up its option to take a 25% stake in ARM. The fund is clearly intending on having a significant influence on the activities of the companies in which it invests as the aim is to supply growth capital and accelerate the development of disruptive technologies.

We are pretty sure that this will also involve turn-around situations as most disruptive technology and requirement for growth capital is to be found in small companies. With the Vision fund’s lowest investment size at $100m, start-ups and small companies are clearly off the table. The main investors are SoftBank ($28bn), the Public Investment Fund (PIF) of the Kingdom of Saudi Arabia ($45bn estimate) and Mubadala from United Arab Emirates ($15bn estimate). We estimate that between them they make up 95% of the funds committed. Apple, Qualcomm, Sharp and Foxconn Technology Group make up the other 5%. The fund will shave the option to acquire a 25% stake in ARM ($8.2bn) as well as some or all of SoftBank’s investments in Guardian Health, Intelsat, NVIDIA, OneWeb and SoFi. It is worthy of note that SoftBank’s investments in Alibaba or Flipkart which fit the criteria for the Vision Fund do not appear to be included as potential contributions. If the fund decides to take these investments, they will be offset against SoftBank’s $28bn commitment to the fund.

The biggest issue that the fund will face will be pressure to find good investments. Rivals such as KKR, Blackstone etc. have grown their asset base over time but here the Vision Fund has $93bn at its disposal from day 1. Consequently, its main shareholders will be wanting to see their money quickly put to work opening the door to making rapid but sub-optimal investments.

We hope that SoftBank’s recent (on ongoing) experience in India will be heeded as an example of what happens when too much capital chases too little paper on a wave of hype and optimism. Common sense indicates that the shareholders will not be putting up all of the capital on day 1 but as the investment opportunities arise, they will contribute their share as per the commitments that they have made. This is made all the more likely as we understand that PIF will be raising the money from other investments that it is holding and Mubadala did not have $15bn of spare cash on its balance sheet at the end of 2016. Although the Vision Fund is the third largest private equity fund globally, it is the largest that is dedicated to technology and consequently, it should be a major player in sector going forward.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

19 May 2017

Alibaba FQ4 17- Intuitive integration

Signs that Alibaba is moving to make the most of its ecosystem.

Alibaba has really figured out what it needs to do to become a fully-fledged ecosystem across all aspects of its users’ digital lives

Signs that Alibaba is moving to make the most of its ecosystem. Alibaba reported another excellent set of results which was marred by the normalisation of the tax rate following the ending of a tax break gained by investing in its distribution partner Suning. Alibaba has also begun to demonstrate the kind of traits that lead us to think that it has really figured out what it needs to do to become a fully-fledged ecosystem across all aspects of its users’ digital lives.

FQ4 17 revenues / Adj-EPS were RMB38.6bn / RMB4.35 nicely ahead of consensus estimates of RMB35.9bn / RMB4.86. The main driver of the results was Alibaba’s core e-commerce business which posted FQ4 17 revenue growth of 47% to RMB31.6bn. This was underpinned by 11% growth in the number of active buyers as well as each user spending significantly more with Alibaba than they have in the past. This is how Alibaba has managed to defy my expectations that growth would slow this year.

Cloud computing and digital media and entertainment each posted triple digit growth albeit from a much lower base. The excellent results were marred by an increase in the tax rate which increased to 23% up from 14% in FQ4 16 where it will stay from here. The most notable aspect of management’s commentary was the increasing focus on integration of its digital assets.

This has almost been completed for the digital media assets, giving Alibaba the ability to understand usage patterns across all of its media assets. The same thing is going on in its e-commerce assets and it is already beginning to reap the benefits from this by offering this intelligence back to the merchants on its sites. This kind of intelligence is what could also allow Alibaba have a big impact in offline retail which still makes up the vast majority of Chinese retail spending.

The final step should end up being the integration of all of this data into a single repository. If Alibaba can to this effectively, it will be able to monetise its traffic far more effectively than it does today as well as have the insight into its services to make them richer and better than those of its competitors: Tencent and Baidu.  We still struggle with the valuation of Alibaba but it’s moves towards really making the most of the assets it has makes us willing to have another look.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

18 May 2017

Google i/o 2017 – Brain game.

Superior brains being used to make its services the best.

Google held the first day of its annual developer conference and in its keynote, it highlighted the features and improvements that it is making to its ecosystem to keep users engaged while gathering and categorising as much data as it can. Artificial Intelligence headlined the event with Google’s leading expertise now being implemented in everything that it does.

Google Lens
This is machine vision similar to what many others have also announced but in Google’s case we suspect it will work properly. This can be used to identify items which combined with search to bring up relevant information about it. This stretches from the history and background of a place to the ratings users have given to restaurants and shops. Others fall short in the ability to identify items as well as in the digging up of relevant information about the item. This is because the AI they are using to power the service is not nearly as advanced as Google’s.
This functionality is being rolled across all of Google’s properties to enhance everything Google does such as the Photos app, Maps, Daydream and so on.

AutoML
This is a research project within the Google.ai initiative. It is neural network that is capable selecting the best from a large group neural networks that are all being trained for a specific task. While few details were disclosed, Google said that the results achieved to date were encouraging. This is a hugely important development as it marks a step forward in the quest to enable the machines to build their own AI models. Building models today is still a massively time and processor intensive task which is mostly done manually and is very expensive. If machines can build and train their own models, a whole new range of possibilities is opened-up in terms of speed of development as well as the scope tasks that AI can be asked to perform.
Automated model building is one of the major challenges of AI and if Google is starting to make progress here, it represents a further distancing of Google from its competitors when it comes to AI.

Google also gave updates on all the current products and services including the next version of Android: Android O.

Most relevant updates included:

• Android: There are now over 2bn active Android devices in the market but there is meaningful multiple device ownership. For example in Brazil there are more mobile phone connections than there are people, highlighting that multiple devices are owned by a large number of people. This is a trend that is mirrored in many other emerging markets. Every Google Android device has a Google sign-in and for the other Google services, the figures are closer to 1bn which also includes those that have iOS devices. Hence, in terms of real unique users rather than devices, the numbers are much lower. This is important because it is unique users that generate the revenue for Google and hence they are a better measure of the real penetration of Android across the globe.

• Android Go: This is the relaunch of the failed Android One project which aimed to put smartphones in the hands of more users which obviously, requires much lower cost. Android Go is like a mini-mode of Android O which runs in an optimised way on devices with memory down to 512MB of RAM. Google’s apps have also been optimised to run in this highly constrained environment. Importantly, functionality has been added that focuses on saving data usage as well as offering complete control of data usage from the device. For the lower income users, data has become almost like a currency and this gives them much better control of their “spending”. This looks like a much better proposition than Android One which was highly restrictive to the handset makers. However if they start tinkering with Android Go (as they always do), there is a good chance that all of these good improvement will vanish into thin air.

While this is not the most exciting i/o event in terms of new announcements, it is what is going on with AI that has the most implications for Google’s outlook. AI is now embedded in everything and because Google is clearly the global leader it has the scope to make its services richer and more intuitive than anyone else’s. This is critical because this is how Google will win over more users to its services, generate more traffic and therefore more revenue.

However, much of this is already embedded in the share price and we continue to prefer Baidu, Tencent and Microsoft.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

17 May 2017

Android Project Treble – 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. We have long believed that the inability to update Android OS is one of the biggest problems that Google faces with its ecosystem on Android. 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 we 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. 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 our opinion 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.

We continue to think that Alphabet remains fair value and we would continue to steer clear of the handset makers whose differentiation looks like it may take yet another hit.”

 

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

16 May 2017 · 2 min read

Google Auto - Tinkering with Android for cars is a dangerous game

Ahead of its developer conference, Google i/o, Google has demonstrated another version of Android that will be able of running many more aspects of the car beyond infotainment.

While Android Auto is limited in terms of what it can do and the data that it can access, this version of Android for the car is much more deeply embedded. As a result, we think it will have access to everything as the infotainment unit is the nerve centre of the vehicle where the 4 data networks in the car (CAN bus) meet.

This means that Google services such as Maps, Search and Assistant will be fully embedded in the car enabling these services to be far more contextual and relevant. It also raises the possibility that Google will be able to suck all of the data out of the car, robbing the OEMs of one the most important pieces of exclusivity that they have. Audi and Volvo have signed up to use this software which will be demonstrated on the Q8 and the V90 SUVs at Google i/o this week.

The two most important issues are:

  • First, Code control: Who is in control of this code is crucial to the outlook for the OEMs. From the presentation, we get the impression that the manufacturers are nominally in control of the Android code going into their cars but we seriously doubt that they have done the implementation themselves. This was most likely done by their tier 1 suppliers or even Google itself. While this means that the OEMs will have control over software updates and feature releases, there are almost certainly going to be hooks in the code that Google can still use.
  • Second, Google agreements: If the OEMs have a similar relationship with Google that the handset makers do, it is important to understand what the OEMs have agreed to. Google controls Android through its agreements with the handset makers and given that the OEMs are getting Google services deeply embedded in their systems, something similar is likely to be demanded by Google. Parts of those agreements are likely to include aspects of user interface design as well as the sharing of data.

We view this software as a replacement for the OEM designed software that resides in the head unit of the vehicle. Android Auto and Car Play run on top of the OEM software but have limited access to the rest of the system. This is likely to be the same such that CarPlay will still run as before but Android Auto will obviously be obsolete.

Google has said that the new software will not be draining the vehicle of data but we suspect that Google is referring to how the software behaves as it leaves the factory. Once it is in the hands of the user and he has agreed to a pop message requesting access to data to improve Google services, the reality could be very different. Sharing this data will make Google services on other devices better for the user but critically, this is the data that the OEM needs to hang onto in order to differentiate itself in all things digital in the car.

This is the risk of deploying software that has not been written in-house as the reality is that the OEMs will have no real idea about what they are deploying on what is becoming the most strategically important part of the vehicle. Tesla and BMW are the only ones that seem to understand the importance of this which is why they are the only OEMs we know of that write their own code.

Google has everything to gain and little to lose by helping OEMs use Android instead of their in-house software which is exactly why OEMs need to look in minute detail at this gift before letting it into their holy of holies.”

 

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

12 May 2017

Microsoft BUILD – Enterprise remains the focus.

At Microsoft’s developer conference, it continued to emphasise its move away from being a platform for the consumption of content to one that is primarily for the creation of content. At the same time it cemented its move away from mobile with the migration of its strategy from cloud first, mobile first to intelligent cloud, intelligent edge.

Effectively, Microsoft is signalling two main changes:

 First, device agnostic: Microsoft no longer cares what device the user has, but instead is aiming to ensure that its services work seamlessly across everything that is available. This was embedded in every presentation during the first two days of BUILD where cross device was emphasised time and again. Cortana, Office 365, team collaboration and communication will be increasingly integrated across all the devices that the user has. This was made very clear with the announcement of the cloud powered clipboard where text and pictures copied to the clipboard on the PC can be pasted into non-Microsoft apps on iOS or Android devices. Microsoft employees no longer have to hide their iPhones and Galaxies or take off their Apple Watches when entering hallowed ground in Redmond. We have long argued that cross device is a good way to differentiate an ecosystem that is vying for engagement with the two giants Apple and Google. Microsoft has led in this space for a long time and, as long as this works as billed, it will take Microsoft further into the lead.
 Second, processing at the edge: Microsoft discussed a future where all the processing does not happen in the cloud but part of it is redistributed to the edge for faster response times and greater efficiency. Microsoft demonstrated how running diagnostics locally could cut an emergency shutdown time for a piece of industrial equipment from 2000 millisecond to just 100. However, this is a problem that is supposed to be solved by 5G, which was not mentioned once, further cementing Microsoft’s move away from mobile as a standalone technology. This goes directly against what Intel (and others) is aiming for as its most profitable and highest market share products are the processors that power the cloud meaning that it wants as much as possible to run there. We see a number of schools of thought with regard to how intelligence and processing should be distributed throughout the network with each proponent obviously going for the option that benefits their business the most. We think that the reality will be that different use cases require different scenarios. For example simple monitoring that requires rapid response makes sense in the edge but object recognition and tracking and relating that to policies is a very intensive task that is best carried out on big servers in the cloud.

Microsoft also announced the fall creators update for Windows 10 to support all the cross-device capability as well as badly needed improvements to the Windows Store that is needed to give Windows 10 S a chance. Hololens was also upgraded with the addition of a controller to bring it into line with the other offerings but this remains very much a tool for the enterprise. This was clear in the demos and examples which were focused around productivity with the idea of a virtual shoot out in the living room, thankfully not being repeated.

With every presentation that passes, Microsoft distances itself further and further away from content consumption and the consumer. Consequently, while there is a strong rationale to keep Bing (data generation), we cannot say the same for Xbox, Minecraft and a number of other assets. Hence, we would not be surprised to see them sold off should a good opportunity present itself. The net result is that Microsoft is doing exactly what it should in playing to its strengths and differentiating where it has a chance rather than wasting money trying make a difference where it has no chance.

This sets it up for steady growth with its dominant position in the enterprise, still giving support to the valuation even though the shares have been strong. We still like Microsoft alongside Baidu and Tencent.”

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

11 May 2017

Snap Inc. - Price of opposition

Twitter is in a better position

Twitter is in a better position. A poor set of maiden results highlights that Twitter is actually in a better position because although it is stuck in a niche, it remains unopposed in that niche. Management even had the temerity to laugh off the threat from its much larger and far more powerful rival, Facebook, which is successfully replicating Snap’s innovations to great effect. Q1 17A revenues and adj-EBITDA were $149.6m / LOSS$188.2m slightly below consensus at $158m / LOSS$180m. User numbers also disappointed with 166m daily active users (DaU) compared to consensus at $168m. This is not nearly good enough for a company valued at 31x 2017 EV/Sales which triggered a 23% decline in after-hours trading. The company also burned $155m in cash from operations.

Commentators are already drawing the comparison to Twitter, but this comparison does not go far enough. Twitter is stuck in a niche that it has fully monetised and its attempts to branch out into video are faltering. This means that its outlook for growth remains very bleak. However, in the Digital Life Pie segment of microblogging and related messaging, there is no opposition. This means that once it stops spending money in trying to grow, it should make good but static returns from monetising that niche.

Snap Inc on the other hand still has plenty of growth ahead of it but its core business competes head to head with Facebook’s dominant properties of Messenger, WhatsApp and Instagram. This is where the problems begin as Facebook can easily afford to outspend Snap in every instance and has 7.8x more DaUs than Snap does. Both of these businesses are network based where there is an exponential relationship between the value that can be created and the number of connections that the network has. Furthermore, to continue its growth, Snap has to monetise outside of USA as its US ARPU already looks full at $1.81. Outside of the US the relative strength between Facebook and Snap Inc. is even more in Facebook’s favour making Snap Inc.’s task all the more difficult.

These results were bad because the company has a very high valuation and then missed expectations rather than anything in particular going wrong. However, Facebook’s announcements and the intentions that it made clear at F8 are a concern. Consequently, we see no reason to change our position on Snap Inc.’s fundamental outlook or our valuation of $15.4bn or $16 per share in a blue-sky scenario. Given the increasing risks involved, we would not consider buying until the shares were meaningfully below this value. Between the two, Twitter is the better long term investment but given the choice, we would not have either.

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

10 May 2017

Amazon – Show and tell

Screens help to alleviate digital assistants’ stupidity.

We think that the Echo Show is more about addressing the shortcomings of voice interaction with machines than it is about launching a series of new and exciting Digital Life services.

Amazon has launched an ugly looking device called Echo Show that is effectively Alexa with a 7 inch screen attached to the front. The form factor is disappointing as even Baidu with no hardware experience managed to come up with a far more appealing looking product. Amazon has also upgraded the speakers to give a louder and richer sound profile but we see this being about giving Alexa another medium with which to communicate with the user given the limitations of voice.

The problem is simply that Alexa (and all other others) are far too stupid to be able to hold a meaningful conversation with a user. Google Assistant is currently the best but remains woefully short of what one would consider to be a useful assistant.

Digital assistants were designed to replace the human variety but because their intelligence is so limited, they are unable to hold a coherent conversation with the user. Human assistants do not need to use screens to understand requests, relay information and carry out tasks meaning that the perfect digital assistant should not either.

Hence, we think that the Echo Show has been created to make up for the huge shortfall in Alexa’s cognitive ability. This type of interaction is what Edison refers to as one-way voice where the user asks a question and the results are displayed on a screen. Edison research has found that the vast majority of all man to machine interactions are one-way voice and with this device, Amazon makes these interactions easier. Furthermore, for those that depend on advertising having a screen also helps to maintain the business model of lacing a Digital Life service such as Search or Social Networking with advertising.

Consequently, we think that Google is likely to follow up with a similar product which will take advantage of the fact that the necessary communication apps that the device will use are already installed and ready to use on all new GMS Android compliant devices. In Alexa’s case, it looks like the user will have install another app on his phone in order to communicate with the Echo Show.

The Echo Show will come with all of 12,000 Alexa’s skills but these skills have been designed for a device with no screen and so we do not see the screen improving the already very poor user experience that these skills currently offer. At $230 or two for $350, the Echo Show is priced to sell but we think that volumes will be small given that the vast majority of Echo’s shipments are made up by the cheapest member of the family, the $50 Echo Dot. Hence, we do not see a sudden rush by developers to upgrade their existing skills or develop new ones to make use of the screen.

This is where Google Assistant has a huge advantage as it has already been designed to run with a screen (smartphones) meaning that adapting to having a screen on the Google Home product should be much easier and much better. We still think that Google Home has the advantage here as it has a much better assistant than Alexa, but its lack of developer support for the smart home is starting to be a real problem. Google really needs to pull its finger out and show developers love, especially as Microsoft looks set launch something similar to Echo Show but using Cortana.

We continue to struggle with Amazon’s share price whose valuation we think demands that investors pay for profits that never seem to materialise

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

8 May 2017 · 3 min read

Google vs Amazon - The time for Google to move is now

Amazon is far from standing still in its battle to win the smart home meaning that Google really needs to pull its finger out before it suffers a defeat not unlike that suffered by Betamax at the hands of VHS.

Amazon is already miles ahead of Google when it comes to devices, with over 10m in the hands of users (compared to Google Home at we estimate, 1m), but it is not stopping there. Last week, Amazon and Conexant announced the availability of the AudioSmart 4-mic development kit. This is a piece of hardware that allows third parties to integrate both the far-field microphone technology that the Echo products use to hear the user as well as the assistant itself.

In essence it is an Amazon Echo Dot without the case, being roughly the same size and shape. The idea is that third parties take the kit and integrate it into their own products to provide voice control as well as the ability to control everything else in the house. Ecobee has already taken the plunge by integrating it into its own thermostat and we would not be surprised to see many others follow suit.

Amazon has been extremely welcoming to third party developers giving a lot of support as well as meaningful discounts for running their services on AWS. The same cannot be said of Google as almost every developer we have spoken to has not been complimentary when describing the experience of trying to develop for Google Home.

We find this to be a big surprise because Google’s Android developer program has been huge and thriving for years. This is why Google suffered such a resounding defeat at CES in January where Amazon Echo was everywhere and Google Home was barely to be seen or talked about. Google must act very quickly as even though it has vastly superior product, it is at risk if being swamped unless it starts to materially improve the number of third party products which can be used with Google Home.

Google has its developer conference (Google i/o) on May 17th to May 20th where we will be looking for three things:

  • First, Developer love: Google needs to show creators of smart devices plenty of love and support when it comes to making their products work with Google Home.
  • Second, Google Assistant: Google needs to make the assistant available such that anyone who wants to deploy it on their device can do so easily.
  • Third, hardware: Google should make its microphone array available to anyone that wants to use it. This is more important than one would think as the system needs to able to hear the user from far away even with background noise.
  • This requires some specialised microphones and is important when it comes to delivering a good user experience to ensure engagement and traffic generation.


We still think that smart home is Google’s to lose but unless there is real movement in this direction at Google i/o, we fear that by next year, the game will already be over. Google’s outlook for 2017 remains pretty good but the shares still look fairly priced leaving us preferring Microsoft, Tencent and Baidu.”

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

5 May 2017

Microsoft - Windows 10 S great for schools but not for the Surface Laptop.

For the education of children, Windows 10 S makes perfect sense but for college and everything else, we can’t see why anyone would want it. Microsoft held an education event this week where it launched a new version of Windows 10 called Windows 10 S and a stunningly beautiful laptop called Surface Laptop.

Windows 10 S

The main feature of Windows 10 S is that it is locked to running apps that are available in the Windows store. This allows a greater degree of security as each app will have been checked by Microsoft but also will run in its own container. This has the effect of not bogging down the operating system as often happens as devices age and ensures that performance will always be crisp and quick.

This is ideal for the classroom where all devices should offer exactly the same performance and teachers can’t waste time waiting for the older laptops to boot or load. Windows 10 S also allows the school to take complete control of the device just as enterprises do with the laptops within their organisations. This is highly appealing to schools whose aim is educate the students rather than to offer them a good and fun user experience on the device of their choice.

Microsoft has also added a handy feature enabling the creation of a USB drive that can install all of the required apps, settings and permissions on a Windows 10 S device in one go. This makes the set up and management of devices within a school much easier and faster. The app limitations mean that Windows 10 S can run effectively on devices that compete with Chromebooks which is clearly what Microsoft is intending with this version of Windows.

However, outside the controlled environment of a school, we can’t see anyone willingly running this version of Windows. This is because what is available in the Windows Store is a sad reflection of the wealth of software that is available for the PC. If we take the example of a student at university then this reality is put into sharp focus. Students tend not to have a lot of spare cash and therefore will rely heavily on free software which is they are using Windows 10 S needs to be on the store. Taking the top free PC software as recommended by TechRadar, we found that 3 apps were available compared to 10 that were not but of which, 2 or 3 had something similar in the store.

The Windows Store does not offer Google Chrome, iTunes, Google Drive or any BitTorrent clients, all which we suspect are pretty important for cash strapped students. Microsoft refers to its refusal to install the software that the user wants as a “friendly popup” that directs you to something similar in the store but we suspect that almost all users who have paid for their own devices will find this utterly infuriating.

Hence, to make Windows 10 S gain any traction outside of schools, Microsoft needs to dramatically improve the Windows Store. This will take some time and hence we see virtually no traction for Windows 10 S outside of the controlled education environment for which it has mainly been designed.

The good news is that users can unlock the device by upgrading to Windows 10 Pro for $49.99 (free for students) but how well Windows 10 Pro will run on a $170 PC remains to be seen.

Surface Laptop

Microsoft also launched a beautifully designed laptop that has looks and power but with the price tag to match starting at $999. Every detail has been attended and it is refreshing to see a device maker show such care and passion for a product that it has created. For high end users, who are not fans of the tablet form factor, this is a great option but in that regard, it has no business whatsoever being launched with Windows 10 S.

This product has clearly been designed to appeal to users and hence we suspect that almost every device will be shipped to users who have paid for it themselves. Furthermore, the vast majority of schools, will not be buying this product for their students but rather something much cheaper.

Hence, to create the best possible demand for this product Microsoft should offer the option for the device to ship with a regular version of Windows at no extra charge. This is because we suspect that almost everyone who buys this service will not want to be bound by the limitations of Windows 10 S. After paying up to $2,200 for this device being forced to pay another $50 just to run the apps that the user wants will really stick in the craw.

Microsoft have launched the Surface Laptop as a hero device to encourage the adoption of Windows 10 S on much cheaper devices but it makes absolutely no sense for the device itself to run this version.

The end result is that we like Windows 10 S for school as it will take the fight to Chromebooks which dominate the education landscape in the US. This is especially the case because Office is a far better option for content creation than Google Docs but where Google has an edge is in text books.

Google has spent a lot of time building up a huge library of e-text books for schools and this is something that Microsoft will have to quickly replicate in the store if it wants schools to switch. Furthermore, if Microsoft can win students over to Office when they are young it sets Microsoft up nicely to continue its dominance with Office as these students enter the workforce.

Microsoft looks better positioned in education with this release which to us looks like a very long term, but worthy investment. We continue to like Microsoft which is doing very well in the enterprise and fortunately the valuation does not demand excellence in consumer, where we continue to see indecision and slow decline.”

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

3 May 2017

Apple FQ2 17– New normal

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 our 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 our opinion) given up on making a car, there is no new segment in sight, and so we see Apple, by and large, growing in line with the world economy.

We 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. We see very little upside other than income coming from the shareholder return programs. We would prefer Microsoft, Baidu and Tencent for those looking for capital appreciation.”

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.

27 April 2017

Samsung Q1 17 - Roaring 40s

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 us, this is far more important to shareholder value than re-organising into a holding company.

We view holding companies as conglomerates where good intentions are, more often than not, ground down into inefficiency, bureaucracy and slowness. Consequently, we 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 we reverse out the KRW1.0bn hit that was taken during Q1 17 in the handset business for the Note 7 disaster, we 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, we 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 and pre-orders are pointing to no lasting damage having been done. Admittedly, we 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 us to continue preferring Microsoft, Tencent and Baidu

Disclaimer - Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This document may contain materials from third parties, which are supplied by companies that are not affiliated with Edison Investment Research. Edison Investment Research has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of publication and is subject to change without notice. While based on sources believed reliable, we do not represent this material as accurate or complete. Any views or opinions expressed may not reflect those of the firm as a whole. Edison Investment Research does not engage in investment banking, market making or asset management activities of any securities. The material has not been prepared in accordance with the legal requirements designed to promote the independence or objectivity of investment research.