Quick Thoughts: Apple’s growth is all about the iPhone

Written September 17th, 2014 by

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-          The iPhone 6 and 6 Plus are Apple’s most important products since the iPad and will drive a significant upgrade cycle in its largest and most profitable product area.

-          Screen size parity will pull upgrade demand forward and take incremental share, with a similar geographic roll out as the 5S, suggesting significant upside for 2-3 quarters

-          Apple Pay and Apple Watch have grabbed the headlines, but neither will have more than a small fraction of the impact of the new iPhones on Apple sales and earnings

-          Larger screens were low hanging fruit. It is not clear that there is any further move with close to the same revenue impact available to Apple for 2015’s update.

After years of asserting that the original iPhone’s 3.5 inch display was “perfect for the human hand” and mocking the expansive screen real estate available on the leading Android models as unwieldy, Apple has now fully capitulated. The baby step forward two years ago with the iPhone 5’s 4 inch screen has precipitated a full on leap to the phablet with the iPhone 6 and 6 Plus. The September 9 unveiling was the hottest ticket since Steve Jobs last took the stage in 2011, and brought blissful relief from the unwelcome attention of the iCloud celebrity photo hacking scandal.

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Keeping DuPont Together – Corporate Denial or Corporate Vision?

Written September 17th, 2014 by

With Trian Capital’s letter to DuPont yesterday we formally open a debate that has been expected for some time – whether DuPont can create more shareholder value in pieces than it can as a whole.

At the 64,000 foot level there is empirical evidence that the market is penalizing business complexity more today than in the past – see chart – and this is a subject that we have written about in the past.  This alone is a reason for DuPont to listen to the arguments that Trian is making.

Trian is focused on costs as much as alignment and simplicity and the driver is the a number of “low cost” businesses that have outperformed, such as LyondellBasell, which has a much lower cost structure than for example Dow, while in many of the same geographies and businesses.   See our research for more on this subject.


DuPont is separating its performance chemicals business – and the plan is much evolved at this point, but Trian’s view is that this is not enough.  Their position is that only DuPont’s agriculture and nutrition businesses are truly specialty and require a significant R&D focus, with the rest better run at much lower costs and focused on cash generation.  DuPont has repeatedly maintained that there are significant R&D synergies and opportunities that cross the boundaries between Ag, Nutrition and Materials, driven by bioscience and that is why the businesses should stay together.

The battle lines are now drawn and the question is the one posed in the title.  DuPont needs to provide investors with more concrete evidence that what is so far only an R&D assertion, has some real legs – but now the clock is running.  Working against DuPont are a couple of historic realities:

  • The chemical industry has a history of overestimating the value of businesses as they fall to generic competition, and generally makes divestments a few years later than would have been optimal.  DuPont has done a better job of divestment than most.
  • Company managements often really struggle with the idea of shrinking a company – overvaluing the notion of size.
  • The chemical industry does not generate a return on R&D spending in aggregate and while DuPont claims that it has developed a way to measure R&D returns it has not shared this with investors, perhaps because the results are not what they want.  DuPont has shown better R&D returns than most of its peers, however.

If DuPont is going to win this battle/debate, they will need to do a couple of things in our view:

We would continue to own DuPont here as we think there is substantial upside either from what the company achieves internally or what can be driven through a restructure.

September 15, 2014 – Apple Pay: Friend (and Potential Foe) to the Payments Industry Status Quo

Written September 15th, 2014 by

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Apple Pay: Friend (and Potential Foe) to the Payments Industry Status Quo

Apple Pay combines NFC, TouchID, and HW secured “tokens” on its iPhone 6 to execute retail POS transactions, meeting the security requirements of the card nets (V, MC, AMEX) and issuing banks (JPM, COF, BAC, WFC, C) that will support it. AAPL gains rate parity with “card present” transactions, and a ~15bp fee for providing ID&V assurance and assuming some fraud risk. Alternative RF mobile payment options will NOT be allowed on iOS and Apple Pay will obscure the branding by card nets and banks, threatening the ambitions of many retailers, card nets and issuers. Adoption will be slow – an iPhone6 or Watch is required, just 17% of US stores support it, and the use case is NOT yet compelling. Competitive alternatives will strengthen – the MCX consortium will fight Apple Pay, investment will narrow AAPL’s technical advantage, and open Android provides far more brand flexibility to banks, card nets and merchants. The initial benefit to AAPL will be small –a 15bp fee would bring less than $300M in new revenue. The real benefit to AAPL is in strengthening its proprietary device-centered architecture against hardware commoditization and future cloud-based threats. For now, AAPL is content to leave interchange and network fees in place, preserving the status quo for incumbents, and deny interest in transaction data, assuaging merchants. However, with critical mass, AAPL could choose to monetize Pay more aggressively.

Special thanks to SSR Financials Analyst Howard Mason 203-901-1635, whose contributions were invaluable to this report. Please visit find more of his insightful research on mobile payments

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Apple Pay, Passbook, and the Convergence of Payments and Marketing

Written September 12th, 2014 by


1. Mobile wallets are as much about commerce and advertising as payments; a chip, unlike a mag-stripe, is a messaging device as well as a storage medium for card credentials and so catalyzes the integration of payments and marketing. It is not a coincidence that Apple Pay is implemented through the Passbook app which AAPL is positioning as a repository for digital payments content ( e.g. e-coupons and loyalty rewards) in the same way that iTunes is positioned as a repository for digital entertainment content.

2. Consumers are not likely to adopt mobile wallets unless integrated into an app that adds value beyond the payment; otherwise, apart from security, a phone tap is no better than a card swipe (or, in the case of chip-cards, a slot).

3. Retailers are adopting app-and-mortar strategies to pushback against digital brands; payments-enabled apps support this by digitizing in-store workflows (including e-receipts which, unlike in current approaches such as WMT Savings Catcher, can be integrated into the payments stream) and catalyzing the convergence of physical and digital commerce around and through “omni-channel” strategies.

4. Payments processing margins are low (Apple is reportedly getting 15bps from banks for biometrics), but digital advertising margins are high; Apple Pay emulates a card at point-of-sale and so does not capture transaction details but, through the intermediating API for online transactions, can collect “payment sheet” data.

5. Unlike Android (through host card emulation or “HCE”), iOS controls access to the secure element of theiPhone through the Passbook app, so that issuers cannot push their card to front-of-wallet even in their own apps; this is a drawback for issuers including MCX which is looking to make its payments solution front-of-wallet if not exclusive, and to push network-branded credit cards to the back, if not entirely out, of the wallet.

6. Apple Pay is branding a user experience and, while it has improved the chance of successful launch by working with rather than around the incumbent networks, will likely evolve (as PayPal did) to encompass a variety of payment methods (e.g. ACH) and interfaces (e.g. QR).

Quick Thoughts – Apple Pay Highlights the Business Case for MCX as Retailers Look to Respond to Digital Brands through App-and-Mortar Strategies

Written September 11th, 2014 by

A number of merchants, including MCX members such as BBY, have said they have no plans to accept Apple Pay. TGT has announced that it will enable Apple Pay for online purchases through its mobile app but has not indicated it will provide NFC-enablement for in-store purchases.

This is not surprising. From its announcement in August 2012, MCX has insisted that it will not support mobile wallets other than its own product, which will be branded CurrentC (a play on the word “currency”), with BBY commenting “it is hard to support all of those different technologies and MCX’s view it that one standard is the way to do it”. Furthermore, while MCX members are upgrading point-of-sale technology for chip-based EMV standards (so as to avoid an increase in fraud costs beginning October 2015 under network rules), WMT is urging them not to switch on NFC capabilities but rather wait for the MCX mobile payment solution which, like that at SBUX, will use quick response or “QR” barcodes for transport of card credentials.

A key concern of retailers with NFC-based solutions, including Apple Pay, is that banks are using the mobile channel to promote credit cards over debit cards. Indeed, the promotion of credit cards (with a fee of ~2% of transaction value) has characterized the bank response to the Durbin Amendment which capped debit card fees at just under 25 cents/transaction; one measure of this is that the ratio of annual spending on credit cards to outstanding borrowing has increased to 3.3x from 2.3x in 2009 (see Exhibit). Given iTunes accounts are disproportionately credit, Apple Pay exacerbates rather than relieves the problem and stands in contrast to MCX which, at least initially, will restrict payment options to ACH and merchant-branded (a.k.a. private label) credit.

Exhibit: Banks Have Shifted Consumer Spending to Credit Cards from Debit Cards


We believe this highlights the business case for MCX whose members account for ~$1.5tn of purchase volume. MCX will use a cloud-based architecture for storing card credentials and so will not need access to the secure element of a ‘phone (or SIM card) and will use QR codes for transport and so will not need access to an NFC radio. MCX confirmed in a press release on September  3rd that it is running pilots, will expand these through the rest of the year, and roll-out nationally in 2015; we expect marketing to ramp in the second half and for individual stores to support an umbrella awareness campaign for the CurrentC brand with store-specific loyalty programs and e-couponing.

More specifically, we expect a single MCX app (customized using geo-location to present the logo and coupons relevant to a specific store) along with API’s to allow retailers to include “pay with CurrentC” buttons in store-branded apps. These API’s will be a key driver for adoption of the MCX solution since consumers are already increasingly using retailer apps for in-store shopping (e.g. for product discovery and price comparison), and it is natural extension to keep the app open at checkout for payment particularly if that enables conveniences such as receipt- and coupon-tracking. WMT expects industry-wide, mobile-influenced sales to reach $700bn in 2016 versus an estimated $365bn for e-commerce sales, and sees app-and-mortar strategies as a key weapon to push back against digital brands such as AMZN. In particular, as discussed in our August 25th note, “Payments and the Convergence of Physical and Digital Commerce”, WMT notes “the possibility of bringing the web to the store is incredibly disruptive; we have 140mm shoppers in the US and that is internet scale in the offline world”.

In short, MCX will not so much be replacing a card-swipe with a tap ‘n’ pay as allowing a consumer to complete at checkout shopping experiences that will increasingly begin and evolve on a mobile app. Ahead of the MCX launch, we continue to be cautious on V and MA, and constructive on FIS as the network partner for MCX as well as on COF as a likely private-label credit partner for individual MCX merchants.

Oil – The Big Uncertainty For US Chemicals

Written September 11th, 2014 by

Oversupply in the oil markets has driven pricing lower over recent weeks with Brent hitting lows not seen in many months, and breaking below previous resistance levels.   Oil is the big risk for the recovering US energy and chemicals sector as it is the price difference between oil and US natural gas that drives all of the competitive advantage in the US and is driving the high levels of investment.

Oil can fall much further before most of the initiatives in the US begin to look much more marginal and investment returns are driven to lows that would cause pause for some of the investors.  However, there is a hierarchy of returns already based on the nature of some of the investments and the ones that require the most significant oil/natural gas spreads are probably already being questioned.

We have written extensively about the production costs opportunity in the US, the opportunity for European producers looking to exploit US costs and more recently on the potential advantage of building chemical capacity in the Marcellus rather than the US Gulf.

As oil falls relative to natural gas, not only do we risk the returns, simply from a relative price perspective, but we also risk natural gas production itself as the key incentive to drill in the Western Marcellus, for example, is based on the co-product values of both propane and butane, both of which are priced relative to an export netback, driven by international crude prices.   The most recent data in the chart showed the crude/nat gas ratio expanding as natural gas fell from its winter peak.  The last data point reflects Brent at $98 per Barrel.  This ratio needs to remain above 3.0 for every proposed investment to make sense – including exports of Ethane to Europe.  However, as the ratio falls we would expect US producers to lose margin.  For many products, global markets are oversupplied and it is only the US cost differential that is supporting US profits.

Brent to Nat Gas


Quick Thoughts: T-Mobile’s Uncarrier 7.0 Takes Aim at VZ/T’s Profits

Written September 10th, 2014 by

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-        TMUS’ “Uncarrier” strategy is working with 2.75M gross sub ads including 1M post paid ads in August alone and porting ratios from other carriers at over 2 to 1

-        CEO John Legere unveiled a new strategy to leverage WiFi connections to bolster quality of service and offer WiFi calling and texting globally – a strategy diametrically opposed to the rest of the US Telecom industry that will improve its coverage with little cost

-        Other announcements from Uncarrier 7.0 include a couple of freebies: TMUS will give away personal cell spots to subs for their homes and will offer unlimited texting / visual voicemail on domestic flights via a partnership with GoGo

-        TMUS has been keeping the pressure on the industry, demonstrating innovation and attacking from unexpected angles – T/VZ may not have the strategy and org model to respond

Taking the stage after downing a can of Red Bull and dropping F-bombs has become a staple of TMUS CEO John Legere’s Uncarrier keynotes. This afternoon was no exception as Legere and his lieutenants announced another set of broadsides aimed at destroying the T/VZ duopoly just three months after the last Uncarrier initiative.  In his latest salvo against wireless incumbents, Legere has essentially turned T-Mobile into the first major US mobile virtual network operator by allowing subscribers to use WiFi connections for calling and texting, something rivals have been loath to do given rich margins from cellular data services. The announcement is timely, coming just a day after Apple touted its new iPhone’s ability to seamlessly handoff between cellular and WiFi networks. While rivals have responded in kind by matching TMUS offers and tactics in the past, going WiFi could be very disruptive to the most lucrative source of profit for incumbents.

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Quick Thoughts – Apple Pay and the Convergence of Physical and Digital Commerce

Written September 10th, 2014 by

Apple Pay is an EMV-compliant, NFC-enabled payments solution that will work: (i) at physical stores with EMV-compliant contactless terminals (currently activated at less than 5% of US retail stores but likely to reach 25% by end-2015); and (ii) through apps to make online purchases. As an EMV-compliant solution, it will attract card-present rates for in-store transactions although, of course, card-not-present rates for in-app transactions. Merchants will be drawn to the security features of Apple Pay which uses a static device-identifier to authenticate cardholders and dynamic tokenization to keep raw card credentials out of the phone and merchant systems; and merchants will be reassured that, unlike GOOG, AAPL will not look to capture payments data for an ad business.

While Apple Pay will launch with iOS8 in October on the iPhone 6 and 6 Plus, it will also be available on the iPhone 5 series through tethering to the NFC-enabled Apple Watch scheduled for release in early 2015. This backward extension of Apple Pay to the large iPhone 5 customer base provides additional incentive for merchants to install contactless terminals (although we note that, independently of Apple Pay, member-merchants of the MCX merchant payments consortium, including TGT and WMT, have committed not to activate NFC terminals given their plans for a barcode-based mobile payments solution, as used by SBUX, in partnership with FIS).

Apple Pay essentially extends the Passbook app, which currently works for gift cards with QR codes as transport, to include network-branded cards with NFC as transport. Among the four major networks, only DFS is excluded but this is likely temporary. The top-6 issuers (JPM, C, COF, WFC, BAC, and AXP), representing over 80% of US card payment volume, will participate in the launch with other banks, including USB and PNC, expected to follow shortly thereafter. Banks are giving up fees since they will reportedly pay Apple per-transaction amounts, of up to 25 basis points, in return for fingerprint risk-scores generated by Touch ID that will tend to reduce fraud losses (although these fees will presumably not be paid for transactions initiated on Apple Watch which does not have Touch ID).

JPM has suggested the biggest impact of Apple Pay may be for online shopping rather than in stores because consumers will not need to input card numbers and shipping addresses for purchases using Apple Pay-enabled apps; AXP comments more broadly that “Apple Pay is the kind of innovative thinking that brings the worlds of online and offline commerce closer together”.

As a catalyst for contactless-terminal demand, Apple Pay is positive for market-leader Verifone and, as a competitor to PayPal (with a fee-advantage for in-store purchases given card-present rates are typically 50 basis points lower than the card-not-present rates of PayPal’s solution which is not EMV-compliant), a negative for EBAY. For now, Apple Pay works with, rather than around, the branded networks. However, once consumers have loaded in cards with the iSight camera (or become used to using cards registered to iTunes), AAPL is in a position to enable Apple Pay for barcodes thereby extending its reach to merchants that have not upgraded to NFC and may offer compatible payment solutions that disintermediate the branded networks as in the case of the partnership of MCX with FIS.

Quick Thoughts: Apple – Go Big or Go Home

Written September 9th, 2014 by

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-           The big screen iPhone 6 and 6+ should pull upgrade sales sharply forward, even at a higher average price point than the 5S, yielding 15%+ sales growth from iPhone for AAPL’s FY15.

-           The Apple Watch is beautiful and chock-a-block with technology, but lacks a compelling use case at a price that will stretch the wallets of users already saving for an iPhone 6 upgrade.

-           Pay has uniquely integrated HW and SW for mobile payments, and has a coalition of banks, card nets and merchants, but users get little benefit and the revenue potential for AAPL is small

-           AAPL is positioned for strong iPhone 6 driven results in its 1HFY15, but we do not expect the Watch to be a repeat of the surprising iPad phenomenon. Growth worries will return in 2H.

In a super-sized version of its annual fall ritual, Apple CEO Tim Cook to the stage at the Flint Center in Cupertino to unveil two highly anticipated new iPhone models, a mobile payment solution called Apple Pay, and the company’s first new product category in four and a half years, the Apple Watch. The content of today’s presentation was hardly a surprise given bloggers and the tech press have been publishing leaked photos of the new iPhone as well as commenting on deals between Apple and payments networks in the weeks leading up to the event. Apple’s move into wearables has long been speculated, given the company’s hiring spree of executives from the luxury goods industry over the past year, though the alleged “iWatch” leaks turned out to be no more than fan boy renderings for a future product that is likely not yet in production.

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GS: The Role of Enterprise-Wide Risk Management Systems in Derivatives Pricing

Written September 2nd, 2014 by

“In the old days, there was complexity on products with leverage and pay-off. Now, the derivatives are simple – the complexity is in the accounting. The world has been turned upside down.”  Head of markets at a major dealer.

The financial crisis has transformed the derivatives business which is now relatively less about value-pricing a differentiated product (with a complex payoff, presented as a “customized risk solution”, but also tending to obfuscate fair-value) and more about cost-advantage in commoditized product.

  • In addition to dependence on the credit spreads of reporting dealer and counterparty (given, post-crisis, the decisive industry move away from default-free pricing), the relevant costs are increasingly driven by portfolio effects and particularly the relevant “netting set” as defined by regulators and clearing houses. Indeed, dealers now explain uncompetitive pricing to clients in terms of being “wrong way round” at the clearing house (meaning that a given trade adds to, rather than nets against, credit and/or funding costs).

Investors understand the impact on trade profitability of capital charges, but valuation adjustments can have a greater impact. For example, pioneering analytics provider, Quantifi, estimates the all-in cost of these adjustments at 3 basis points for an at-the-money (ATM) 10-year received-fixed swap versus less than ½ basis point for the cost of capital charges (assuming these are debt-, rather than equity-, funded[1]); in comparison, the bid-ask spread is less than ¼ basis point.

  • As shown in the Exhibit below, the relative impact of valuation adjustments is also high for in-the-money (ITM) and out-of-the-money (OTM) swaps as well as for a stressed-, rather than only base-case market-, volatility scenario.

An increasingly important element of these valuation adjustments, currently accounting for 20-25% of the total, is due to funding; specifically, a funding valuation adjustment or FVA reflects the present-value of expected funding costs for a derivatives-related obligation to post collateral[2]. In 2014Q1, JPM commented that “for the first time, we were able to clearly observe the existing of funding costs in market clearing levels”, and the impact is likely to increase with inter-dealer collateral requirements (as the industry shifts to central-clearing and extends the collateral requirements of central-clearing to bilateral trades) and as rates normalize.

  • For example, Deloitte[3] estimates that the cost of posting T-bills or agency securities as collateral will double with an increase in the effective fed funds rate from 0.1% today to 2%.

Mitigating this increase in the funding costs of collateral will be important to competitive advantage, and requires enterprise-wide technology to link front-office pricing to optimal choices in the middle- and back-offices for both clearing venue (and trading venue when clearing is not “open” because of vertical integration with trading) and cheapest-to-deliver collateral (across repo, OTC derivatives, and listed derivatives businesses, for example). We see GS as the leader in this enterprise-wide risk-management technology, and associated pricing-support tools for traders.

  • In May, for example, President & COO Gary Cohn commented: “We made a decision to have a single unified risk management system for all of Goldman Sachs. We have one risk management system that everything in the world goes in that calculates every potential cost, and shows every trader every possible outcome, every possible way to hedge that can go on. And they can literally manipulate anything they want within the system. It’s got an enormous amount of data”.


[1] There is a case for using the shadow cost of capital which would be higher than the own credit spread at 0.5% and as high as the target ROE (i.e. at least 10%) for firms with tight capital constraints.

[2] Of course, there is no FVA in the pre-crisis environment when derivatives cash flows are discounted as the same rate assumed for dealer funding costs. Now, however, dealer funding-rates are not assumed to be risk-neutral so that an FVA arises when there is a collateral mismatch and the dealer needs to borrow to fund the difference as can occur when the original trade is with a collateral exempt end-user but the hedge, as is typical, is with another dealer and increasingly centrally-cleared. In this instance, when the original trade is in-the-money, the hedge has negative present value creating a collateral requirement in the inter-dealer market particularly in a centrally-cleared environment; this collateral is not funded by the original (uncollateralized) trade, so that the reporting dealer needs to borrow in the open market.



Please see our published research for the full note and tables.

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