Archive for June, 2011

It has been just 4 years since the introduction of the iPhone.  In that short time, Apple, joined in bitter competition by Google and its Android ecosystem, has laid waste to the traditional cell phone industry and with the popularity of the smartphone’s younger but bigger brother, threatens to render the venerable PC obsolete.  The trajectory of the Apple/Google rivalry is driving both companies to define their platforms as suites of services that reach far beyond the device and make it doubly difficult for would-be contenders to get back into the game.  Hewlett Packard, Research in Motion and Microsoft have all made clear their intention to compete, each claiming a better mousetrap and an ability to exploit strength with enterprise IT buyers.  We are skeptical and grant only Microsoft better than even odds of surviving the mobile platform wars

Apple’s simultaneous announcement of its new iCloud service and its revamp of the iOS operating system is a spur to the ribs of its arch rival Google and its Android ecosystem, but also a stark challenge to the would-be rivals circling below.  It will not be enough to offer a competitive standalone smartphone or tablet OS.  Future user experiences will be defined not just by the functionality, ease of use and performance of the device, but also of the network-based services tied to the device.  These services geometrically expand functionality extending across multiple devices, but require deft integration, and severely tax the delivery infrastructure.  As this evolves, mobile devices will be just a piece of an end-to-end service controlling the way that consumers communicate, access information, transact business and entertain themselves

A key question for Hewlett Packard, Research in Motion and Microsoft is how quickly an enterprise specific market for tablets and smartphones will emerge.  Relative to consumers, IT departments have different priorities – i.e. application customization, security, organizational control, and vendor diversification – that may favor alternative platforms and traditional IT vendors.  We believe that the pace of adoption will be set by the movement of enterprise applications to the cloud and the acceptance of portable devices as appropriate replacements for PCs, developments that are finding a bleeding edge now, but will take a few years to become commonplace.  Given scale economies and the grass roots pressure on IT departments to support consumer mobile platforms, we believe an enterprise only approach is unlikely to be successful

Hewlett Packard and RIMM have flailed in the smartphone market and are both late to the party with tablets that have generated some “geek cred” buzz.  Even if the devices live up to the expectations of the blogosphere, both companies face an uphill battle.  Neither has established a meaningful ecosystem of commercial partners.  Both have tired consumer brands and tepid distribution support.  Neither appears to have the intention or wherewithal to deliver a viable end-to-end service response to Apple’s iCloud challenge. Both are subscale and, likely, high cost.  We view both companies as unlikely to thrive in the smart portable device market of the future

Microsoft’s position is slightly better.  Mobile Windows7 smartphones have been on the market for a year, having gained critical kudos if not market momentum.  An update, pitched for tablets as well, is due before year end.  Microsoft has established a modest ecosystem of device partners, with Nokia the notable new enlistee.  The brand is far more valuable than either HP or Blackberry and carriers view Mobile Windows as a best alternative to ward off an Apple/Google duopoly.  Importantly, Microsoft may have enough pieces to deliver a viable consumer cloud strategy, with both applications and infrastructure in house.  Microsoft’s scale is really that of its manufacturing partners, which include the four largest non-Apple mobile device makers.  If Microsoft’s next version, code named “mango” meets delivery targets and technical expectations, and if its hardware partners hit their marks as well, Mobile Windows may live to see its positioning with enterprise IT managers actually mean something

As for Apple and Google, their strategies, though equally comprehensive are a study in contrasts.  Apple’s approach emphasizes integration, both of the user experience and of the company’s value chain.  By keeping the most important elements in house – processor design, device design, application distribution, retail, branding, and now, cloud service design and operations – Apple is able to deliver a rigorously coherent and intuitive user experience that remains its biggest advantage

Google leverages the reach of its ecosystem partners, including the biggest device manufacturers and wireless carriers in the world, to flood the market with choice, while iterating three system upgrades in the time its rival completes one.  Speed is Google’s ace in the hole, and its biggest manifestation is in the company’s distributed data center infrastructure, which puts more processing power and storage closer to more users, thus assuring lightning response from its cloud-based services

Like most, we believe Apple and Google will sustain leadership at the top of the device food chain.  Between the two, we favor Android, as its ecosystem is fueling a faster innovation and broader choice, while Google’s infrastructure is a sizeable and unappreciated advantage as the market runs headlong into the cloud era.  We expect the tablet market to play out similarly to smartphones, with Android software catching up to iOS in both functionality and market share, with Apple sustaining itself as a premium priced and super-normally profitable number two.  We also believe that Microsoft’s Mobile Windows will establish itself as a viable third alternative, with particular strength in the slowly emerging enterprise market, but that neither HP’s WebOS or RIMM’s QNX OS has enough momentum to survive

Historically, bottom fishing has not been a successful strategy for tech investors.  However, the extreme nature of the current market calls this truism into question.  Today, nearly 20% of all technology companies with market cap of more than $3B trade at cash adjusted forward P/Es of less than 10x and have free cash flow yields in excess of 10%.  Putting this in perspective, assuming a market beta, 15% yield equates to FCF declines of 10% per year over 20 years, with no terminal value.  These stocks are priced to fail – many of them quickly and spectacularly

Grouping 26 companies into categories, 7 are “old line” IT systems companies, 6 are suppliers to the PC value chain, 3 are share-losing mobile device makers, another 2 are document processing specialists at risk to a paperless future, and 3 more are niche communications technology suppliers in the midst of industry change.  The remaining 5 – 3 are non-PC semiconductor manufacturers, and 2 are semiconductor capital equipment suppliers – are inherently cyclical and their valuations reflect the anticipation of an ebb of their currently strong cash flows

The first two categories turn on the same issue.  A new IT paradigm based on thin, portable devices, wireless networking, and internet-based cloud applications threatens to make the previous architecture based on increasingly powerful PC-based devices networked to private data centers obsolete.  “Old line” systems providers, such as HP, Microsoft, Cisco, and Dell, generate the majority of sales and earnings from the status quo – PCs, desktop applications, enterprise Ethernet networks, Windows-based servers, etc. – and thus, will likely face a slow, but irreversible deterioration in their core markets.  Similarly, PC-suppliers face a double-whammy of weak future demand in a core business and severe fixed cost leverage typical of a cyclical

While we wholeheartedly back the paradigm shift thesis, current valuations imply an excessively gloomy future.  We believe efforts to “milk” traditional franchises for maximum cash flow may prove successful for forward thinking players, and some companies may be better positioned to address the opportunities created by the new paradigm than is commonly assumed.  This creates opportunities for investors willing to wait out the poor sentiment plaguing these stocks, but caution and patience are advised.  In assessing these opportunities, we have rated companies as to their exposure to deteriorating markets and their position to exploit new opportunities.

Amongst the systems companies, we estimate exposure as the percentage of cash flows from hardware and software tied to Windows/x86 device platforms, to enterprise level Ethernet switching and routing, paper-based document processing, and traditional client-server data center architecture.  These businesses face commoditization in the near term and obsolescence in the longer term.  We rate Microsoft as the most exposed company of the 7, and Cisco as the least.  For suppliers, exposure is based on estimated cash flows specifically from PCs.  Here, Intel is rated the most exposed and Flextronics the least.

Positioning against the emerging new paradigm is a more subjective consideration.  For both systems companies and component suppliers, we consider the applicability of current products, technology assets and skill sets, and the progress in addressing future opportunities in thin smart mobile platforms, wireless broadband, CDN architecture, public cloud data centers, and cloud-based applications.  Amongst systems companies, we see Microsoft and Cisco as fundamentally well positioned, but HP, Dell and the others as poorly positioned.  Amongst component players, SanDisk is well positioned for mobile devices and Western Digital and Seagate should eventually return to growth from cloud installations, while Intel appears particularly misaligned.

Noting that pressures on traditional core businesses could continue to feed negative sentiment for several quarters, we believe that the balance of risk and reward make several of the companies on our list appropriate for long term investors.  Amongst systems companies:  Microsoft faces enormous headwinds, with 30% of sales from Windows on devices, 30% from business applications that will see vigorous new competition, and 24% from server software.  Nonetheless, we believe it is positioning itself to be a leader in cloud-based applications and hosting, a reasonable #3 competitor in portable device software, and a viable residential gateway.  Cisco battles the commoditization of nearly a third of its sales and more of its profits, while suffering from its exposure to the moribund Government market.  On the positive end, it should profit from seemingly endless growth in demand for internet capacity, and thus core routing and optical gear, and from on-line media streaming, where its prowess in digital video processing should prove invaluable.

On the component side, SanDisk stands out as well positioned – its flash memory products play well in the thin, smart, portable devices expected to dominate the future.  Western Digital and Seagate will certainly suffer from the PC’s golden years, but the shift to the cloud will bring with it huge demand for cheap storage, a concentrated market dominated by these two hard disk drive makers.

To the negative, we are concerned that Computer Associates, Hewlett Packard, Dell and Intel are both highly exposed and poorly positioned.  To the extent that the pace of change remains modest, these companies may show short term strength through cost controls and share gains, but all remain vulnerable to the long term trends.