Archive for February, 2011

Internet advertising has grown at a better than 17% CAGR over the past decade to comprise 10% of the US market, or ~$24 in 2010.  Comparatively, mobile advertising remains small – eMarketer estimates just $750M in mobile ads for 2010 (likely not including mobile search).   However, from this small base, US mobile advertising is expected to grow to $5B or roughly 15% of total on-line advertising by 2015, with global projections 3X higher.  With the proliferation of smartphones and tablets, we believe that the market can maintain better than 20% annual growth through the end of the decade, eventually overtaking on-line ad spending intended for a stationary audience

The biggest driver for the mobile market has been dramatic growth of smartphones and tablets.  The total number of US smartphone subscribers is expected to nearly double from 60M 2010 to 109M in 2015.  Similarly, the iPad launched in 2010 with nearly 15M units sold worldwide.  A flood of competitive Android-based products are coming to market, with Gartner projecting more than 200M total tablets to be sold world-wide in 2014.  Assuming the US to be roughly a third of the global market, the American installed base of tablet users could also push 100M by mid-decade

The emergence of apps as the primary content delivery mechanism on a more standardized population of smartphones and tablets has made serving this rapidly expanding community with advertising a simpler proposition.  Ads can be sold and served beyond carrier and device limitations, potentially reaching the full installed base of a specific OS platform.  With Apple and Google having established large and relatively cohesive mobile communities accessible via common app stores, mobile audiences have reached critical mass for advertisers

Mobile has several intrinsic benefits for advertisers.  First, it is even more targeted than traditional internet advertising, as mobile platforms are not typically shared by multiple users and demographic and platform information about the user are available.  Second, the ability to pinpoint the location of a mobile user is invaluable for delivering advertising close to the time and place of a purchase decision.  Third, the pocket portability of mobile devices allows the paperless delivery of tickets and coupons for direct redemption, and eventually, of mobile payments at point of purchase.  These advantages increase the precision and effectiveness of advertising, enabling delivery to the right audience and increasing the potential of completing a sale

Both Apple and Google have made mobile advertising a strategic priority, evidenced by Google winning a fierce bidding war between the two for mobile ad pioneer AdMob in late 2009.  Apple countered by acquiring AdMob’s primary competitor Quattro Wireless and rebranding it as iAd.  Google has revealed that it generated roughly $1B in mobile ad revenue in 2010, half from the US, while Apple has not indicated its progress with iAd

Characteristically, Google’s mobile advertising strategy has been broad, coupling mobile search with app linked display advertising across its own and its competitors’ platforms, while seeking to partner with app developers, content providers and carriers to establish an entrenched end-to-end advertising and mobile payments ecosystem.  Apple has been more targeted, seeking to establish a high premium for access to its famously rabid customer base, with significant restrictions on the ability of its app, content and carrier partners to participate

In contrast, Facebook has been quiet on the mobile front, with no discernable revenues, but this could soon change.  The social network juggernaut has begun to push its 200M mobile app users to use its Places “check-in” facility, and recently acquired “stealth-mode” hyper-local advertising Seattle start-up Rel8tion.  Moreover, HTC recently announced a trio of Android-based smartphones with dedicated Facebook buttons

Many wireless network operators are exploring ways to gain a viable stake in mobile advertising.  AT&T has announced a mobile software development kit (SDK) to leverage its yellow pages asset in pursuing the local advertising market.  Telefonica is attempting to create a 25 country one-stop shop for advertising in its served markets.  While Apple appears to be unwilling to cut operators into its advertising strategy, Google seems willing to leave a modest role for them.  The recently announced Microsoft/Nokia alliance would seem to be even more open to sharing the advertising opportunity with its carrier partners, who will be vital if the platform is to survive, much less thrive

Location-based services (LBS) start-ups will also vie for the nascent mobile advertising market.  The $6B+ valuation placed on Groupon, and the buzz around companies like Foursquare, Yelp, and Gowalla reflect the extraordinary potential of tying on-line advertising and promotion directly to physical buying experiences.  These businesses could revolutionize local advertising and promotion, and co-opt tens of billions of dollars in spending that is not well documented in national advertising statistics, thus adding to the potential of the whole mobile advertising market.  Google has already made a run at Groupon and Facebook acquired the aforementioned Rel8tion, while Amazon has yet to “check-in” to the local LBS market

Handicapping the battle of the titans, we believe that Google, followed by Facebook are best positioned to capture the mobile advertising opportunity.  Apple will be aggressive, but is limited by its closed ecosystem and premium pricing philosophy.  Amazon has the business assets to make a play, but has been slow out of the gate.  We are not optimistic that carriers can insert themselves in this market, but believe that one or more of the LBS companies may break-out to independent success

Another month, another major industry event.  While these things usually offer nothing particularly earth shattering – the main reason we decided not to foot the bill for a week in Barcelona this year – this week’s news flow filled in a few details to the always murky picture of the future.

Apple – Will it Be Smaller or Cheaper? The Wall Street Journal, which has been accurate in the past on its Apple scoops, is reporting that Apple will introduce a half-sized iPhone this summer, while the New York Times counters that the iPhone5 is the only new smartphone for the summer and that the company is considering a cheaper, but not smaller, addition to the line.  While expanding the product line could greatly increase Apple’s addressable market and counter the proliferation of Android devices, the decision does not seem as cut and dried as many assume.  A smaller product would still be an expensive phone to build, would be incompatible with many apps, and would likely compromise the user experience.  A defeatured model would be cheaper to make, but could also compromise the user experience.  In either case, removing mobile data connectivity would drastically reduce carrier subsidies.  Given the planned launch of the updated iPhone5 in June, it would seem unlikely that Apple would detract from it by launching a product line extension close on its heels.  Given this, we are more inclined to believe the Times than the Journal.

Lotsa New Androids. The drumbeat begun at CES continued at the Mobile World Congress.  This time the Asian’s took center stage with a panoply of smartphones and tablets built on the Google platform.  We have Facebook phones from HTC, 3D phones from LG, hard-core gamer phones from Sony Ericsson, bargain priced phones from ZTE and enterprise-focused models from Samsung.  We have tablets galore in a range of sizes, colors and configurations.  Add these to the Motorola onslaught from Vegas.  Moreover, chipmakers Qualcomm, Broadcomm, Nvidia and Samsung all announced new silicon platforms to power a next, next generation of Android devices next fall.  We expect the market for smart portables to power forward, consuming the sizeable markets for feature phones and PCs along the way to creating entirely new utility for users.  Apple’s brilliance in design makes them a formidable competitor, but their up-market focus, tight platform control and taste for high margins leaves much of the market to the Android ecosystem, and its wider range of niche products, price points and global carriers in distribution support.

Subscription Wars. The day after Apple revealed the details of its subscription program for publisher Apps on the iPhone/iPad platform, Google followed with its considerably more publisher friendly version of the same.  In Apple’s version, any publisher wishing to offer subscription-based content apps would have to offer the same or better price as available through other connections, could not offer links to other paid content through the app, would receive limited data about the purchasers of their subscriptions and would have to pay Apple 30% of the revenue.  Google will ask only 10% of its publishers, has no stipulations on pricing, will not restrict outside links and will pass through the relevant subscriber data.  The differences are emblematic of the differences in strategy between the two players – Apple is focused on control and margins, while Google is focused on gaining the largest possible audience for serving advertisements.  It will be interesting to see if any major publishers balk at Apple’s more onerous terms.  If so, it could greatly strengthen Android in the tablet market, and perhaps force Apple to reconsider the details of its program.  At this point, we suspect that the iPad/Android tablet dust-up will play out similarly to the Smartphone battle.

Microsoft/Nokia Start Their Survival Team-Up. The clock has started ticking on the much discussed Redmund/Espoo connection, as further details of Microsoft’s 10 digit financial support for Nokia’s development efforts, of products already underway, and of Mobile Windows licensee HTC’s thumbs up on the new ecosystem partner.  After four years of both companies standing immobile, mesmerized by Apple’s headlights, many investors are quick to right them off as roadkill, but we are somewhat more optimistic, as we wrote last week.  Regardless, the team-up of deep-pocketed mobile players is unambiguously bad for the other bronze-medal contenders Research in Motion and Hewlett Packard.  Global carriers remain the primary distribution channel – they have never been enamored by the Blackberry business model, which cut them out of the lucrative NOC revenue stream, and have little history with HP.  A viable Microsoft/Nokia alliance squeezes shelf-space for both alternatives and weakens Blackberry’s position with IT managers.

Dell Beats Expectations. 4Q beats by Dell, Lenovo and Nvidia have emboldened the dwindling crew of Wintel acolytes to call foul on the growing PC death watch.  We have been singing the requiem for the moribund platform as lustily as anyone, so the rebound in sentiment bears notice.   Dell and, particularly, Lenovo are share gainers, with Lenovo riding exceptional strength in China and emerging markets to 20%+ shipment growth in 4Q.  Both companies saw significant improvement in margins, as sharp reductions in component pricing were captured rather than passed through to customers.  While these numbers may seem encouraging, we note that overall industry PC shipments were estimated to have grown just 3.4% YoY in 4Q, with most industry observers continuing to take down full year expectations for 2011 market growth.  Moreover, the PC industry has not historically seen OEMs sustaining margin improvements, as price competition from share laggards erodes the benefits of cheaper components.  The demise of the PC market will take many, many years, but the inflection from growth to decline will be soon upon us.  As such, we see improving sentiment around the PC value chain as misplaced and only temporary.

This morning, in an entirely telegraphed but still shockingly radical shift in strategy, new Nokia CEO Stephen Elop announced a comprehensive smartphone partnership with his former employer, Microsoft.  Most observers have been justifiably critical of both erstwhile innovation leaders’ efforts to cope with the iPhone phenomenon to date, and the alliance begins life under a heavy cloud of skepticism.  Earlier in the week, Google engineering VP Vic Gundotra tweeted “Two turkeys do not make an eagle” – a not so veiled shot at the pending team-up that seems to have been taken to heart by investors.  Against the grain, our take is “better late than never”.

The first step on the road to any recovery is admitting that you have a problem.  Elop was appropriately evocative when he likened his company to an oil worker standing on the edge of a blazing drilling platform.  Leaping into the North Sea, or into the arms of Mister Softee, may have unattractive consequences but it is unequivocally better than burning to death standing in place.  Nokia had largely frittered away its pioneer position in smartphones, stubbornly remaining on a path of slow and steady incremental improvement that had allowed it to retake lost market share in the wake of Motorola’s post RAZR self-immolation. This doesn’t work when the competitors are Apple and Google. Four years after its commercial introduction, Nokia still hasn’t delivered a viable response to the iPhone.

This recent legacy of failure is apparent to Elop, and likely drove him to his decision to cut bait with Nokia’s internal smartphone software design ambitions.  Yes, controlling an ecosystem from its core software is the ideal way to create value in the modern smartphone world, but not if your core software is perpetually years behind its competition in an environment of blazing innovation.  Nokia’s old Symbian partners – Sony-Ericsson, Motorola, Samsung, Panasonic, Fujitsu, and others – have long since abandoned the platform in favor of Google’s Android.  MeeGo, the Linux-based Nokia driven iPhone/Android alternative, has missed multiple delivery dates and has generated little enthusiasm amongst potential hardware partners or applications developers.  Better to jump than to burn.

Given that controlling its own destiny was realistically off of the table, Elop looked for partners.  Obviously, Apple was not going to license X-OS.  While we believe that Android will be the predominant standard for smartphones and tablets going forward, Nokia is years behind competitors who have been working with the software standard to tailor it to their own strategies.  In this context, Microsoft is an intriguing partner.  Mobile Windows 7 is an excellent piece of software, with strong technical reviews and clear differentiation vs. the Android/iPhone nexus.  What it lacks are scale, marketing oomph, and distribution channels, things that Nokia can provide.  In this, Nokia and Microsoft need each other, bring substantial resources and assets to a partnership, and likely have forged a mutually beneficial financial relationship that will not render the resulting products uncompetitive under the weight of an untenable royalty structure.

So thus, the former dominant leaders from the PC and cell phone worlds are cast into the role of underdogs in the mobile device market that is superseding the once separate ecosystems.  In this, they have the support of the global carrier community that fears the co-dominance of Apple and Google and their inherent strategies to marginalize them into dumb pipes.  They have Nokia’s global scale and still formidable marketing and distribution into the developing world.  They have Microsoft’s differentiated platform and still formidable position with enterprise IT departments and PC applications ecosystem.  In this, we believe the allied Nokia and Microsoft have a better shot than do Research in Motion or Hewlett Packard, both of which stand alone and neither of which sports the advantages of the Espoo-Redmund connection.

While the fallout from this wrenching course shift will undoubtedly batter Nokia financials for a year or better, and the benefits to both partners are unlikely to be apparent until the real fruits of collaboration hit the market in 2012 and beyond, we believe that it is greatly in the best interest of both companies and their shareholders.  Of course, it will depend on the speed and the quality of execution, factors that have not been evident in either of the parties in the past few years.  Acknowledging that, these are proud organizations with strong managers that we believe can distinguish themselves once freed from bureaucracy and the weight of supporting technology legacies.  We believe that there is a sizeable opportunity to address the slowly emerging enterprise market for portable platforms, to serve the large majority of the market that will never be able to afford an iPhone and to deliver the smartphone experience to more difficult to reach geographies.  Nokia and Microsoft can take leadership if the execution is there.

From a stock perspective, the benefits for the two companies are far enough out that the investment opportunity may not yet be upon us.  We believe that both companies will be survivors through this, and once the pain is fully reflected, suspect that both will be very attractive investments.  This deal also increases our skepticism as to the viability of both Research in Motion and HP in the mobile market.  Meanwhile, the mobile platform revolution continues apace, and whether or not Nokia and Microsoft make this work, Apple and Google can be expected to continue their extraordinary rise in smartphones and tablets, to the detriment of traditional PCs and cell phones

TMT investing has historically favored thematic strategies, as innovation repeatedly remakes the landscape in favor of those able to exploit the rapid pace of evolution in the sector.  This is doubly true amongst small cap stocks, as traditional value and growth metrics have been unusually poor correlates to forward returns for investors.  While these effects may appear idiosyncratic to quantitative models, they have fueled strong performance for stocks associated with in-favor themes.  In the course of our work, we have focused on smart portable devices, 4G wireless, content delivery network architecture, cloud-based applications, on-line/mobile advertising, streaming media and LED lighting as the center of a tectonic shift in the TMT landscape.  We believe that these areas may offer particular opportunity for small cap investors

We believe that current market conditions are benign for small cap TNT stocks in general.  Small cap valuations have been stable relative to large caps over the past year at a very slight premium to historical levels on most valuation metrics.  TMT small caps have also tended to slightly outperform relative to large caps during periods of broader economic weakness, a correlation that suggests conventional wisdom to the contrary may be misplaced

Moreover, overall small cap market valuations do not appear to drive individual stock performance.  Small cap companies are more thinly covered than their large cap brethren, yielding more earnings surprises, bigger earnings surprises and more pronounced market reactions to surprises.  This contributes to a much wider dispersion of returns for small cap TMT stocks than for large cap.  The obvious implication is higher rewards for sharp stock picking for small cap investors, with significantly higher first quintile performance of small caps even during stretches of large cap outperformance at the mean

For small cap TMT companies, most traditional predictive metrics, such as P/E, sales growth, and return on equity have had small or counterintuitive correlation with relative forward returns, with PEG, and Free Cash Flow showing stronger, but still modest, relationships.  In contrast, large cap TMT stocks show stronger and more significant correlation in expected directions for most of these variables.  The idiosyncratic nature of small caps becomes more apparent as the market cap threshold for inclusion in the analysis is reduced

Of 543 publicly traded TMT companies with market capitalization between $90 million and $3 billion, we have identified those tied specifically to the 7 areas of disruptive innovation called out in our research.  Collectively, the 208 companies in these categories have delivered returns more than 1000bp higher than the remaining 337 over the last 12 months.  Of these, the 27 companies associated with CDN architecture have delivered 56% returns, with smart portable devices, LED lighting, and on-line/mobile advertising each over 40% and 74 cloud computing companies averaging better than 35%.  Average sales growth was best in smart portable devices and 4G wireless, while LED lighting companies enjoyed the highest P/Es, followed by media steaming and cloud computing

Screening these companies by P/E, sales growth and FCF yield suggests a lists of candidate companies positioned in high potential opportunities and that exhibit statistical characteristics historically associated with superior returns.  Using these screens, we have selected a model portfolio of 25 small cap TMT stocks.  While we do not specifically recommend these stocks, they are representative of small cap investment choices that we believe are appropriate in the current environment