China Gatecrashes Smartphone Market With Cheap Clones…

The smartphone market has had five years of turbocharged growth, but success will increasingly be determined on selling price rather than device branding as the key hardware technologies become commoditised. Last week, Apple’s share price decline from its September peak reached over 35% on underwhelming revenue and margin guidance, while Samsung also expressed caution on average selling prices for its smartphones.  As developed markets reach 50% plus penetration rates (over 60% in the UK and Spain), the incremental buyer will come from an emerging economy and be inherently more price sensitive. A key technology trend which will pressure margins is the launch of cheap ‘system on a chip’ processor designs from vendors including Qualcomm and MediaTek, which level the playing field for aggressive Chinese entrants like Huawei and ZTE. Meantime, the 4G networks being rolled out globally have been designed primarily for data rather than voice and use the same TCP/IP protocols that underpin the internet, so that the new generation of 4G/LTE (long term evolution) phones are optimized for streaming video and even multiplayer online games.

Value investing in technology can be dangerous, given ever faster product cycles and tumbling barriers to entry. When RIM’s share price hit over $60 in early 2011, it had PER, P/B price/sales ratios very similar to Apple recently, just as margins and revenue dropped as it followed Nokia in missing a rapid market shift and the stock slumped 90% over the subsequent 18mth period. The fast accelerating growth in Android focused mobile apps reduces Apple’s ‘user experience’ competitive advantage, but will benefit Chinese handset manufacturers as much as Samsung, as they are device agnostic.

The rise of the ultra-cheap smartphones from upstart vendors like China Wireless which run on Google’s Android OS and use off the shelf chip designs is going to transform the industry over the next couple of years, which will see the sort of price and margin pressure experienced in LCD/LED TVs, where sustaining a sustained brand premium has proved impossible amid endless discounting. Apple faces a tricky decision in how far it risks diluting its brand premium by introducing a lower cost ‘iPhone Lite’. Samsung’s overall growth in Q4 was driven by the handset business, which accounted for well over half the group’s operating profit for the year. Sales in the division rose 58% in the final quarter y/y and profits 89%, driven partly by strong uptake of the Galaxy series devices. The total smartphone market reached about $240bn in 2012, up 34% y/y, and smartphones now comprise of 83% of the global market by revenue (or 40% by unit volume). Apple’s share of global handset revenue is 29%, but only 7% of global handset units as Apple charges $618 per phone vs. the industry average of $149, given most basic mobile phones are priced below $50.

However, the company highlighted an uncertain outlook by breaking from its usual practice of giving a target figure for capital expenditure this year, but indicated that it would be similar to last year’s $21.5bn. The key line from the statement was that: “In the first quarter, demand for smartphones in developed countries is expected to decelerate.” That slowdown was inevitable given the typical pattern of penetration rates for new technology. Most independent analysts estimate that LTE smartphones with wholesale ASPs under $200 will account for the bulk of smartphone shipments within four years.

The market has plenty of unit sales growth potential as feature phones get upgraded; smartphone shipments will account for 50% of all handset shipments by 2014 and become the largest handset segment in the world, according to the latest market forecasts by market intelligence firm ABI. By 2018, smartphones will account for 69% of all handset shipments, and LTE handsets half of that smartphone total. It’s feasible that at the premium end of the market, Apple will be chasing Samsung’s technology leadership in 2013 through the foreseeable future. Since 2010 Samsung has grown its smartphone market share from 8% to over 30% in 2012; meanwhile Apple’s market share is expected to peak in 2013 at 22%; remaining flat through 2018. However, both companies face growing pressure from new entrants competing on price, as well as Nokia and RIM’s efforts to restore their lost market share (with a combination of the latter with Lenova an intriguing possibility).

Technology Drives US Energy Revolution…

The dramatic shift in the US energy balance as a result of shale gas/oil fracking technology is a theme I’ve often highlighted, and the chart below has global ramifications across many industries. US oil imports will fall to their lowest level for more than 25 years next year according to the US Energy Information Administration (EIA). Net imports of liquid fuels, including crude oil and petroleum products, would fall to about 6m barrels per day in 2014, their lowest level since 1987 and only about half their peak levels of more than 12m during 2004-07. The figures reflect the spectacular growth of US production thanks to the unlocking of “tight oil” reserves using hydraulic fracturing and horizontal drilling in states led by North Dakota and Texas.

The declining US dependence on imports will reduce the trend current account deficit and offer long-term support to the USD, increase resilience to crude price shocks and generate high paying jobs in the energy sector directly (and the highest paying non-graduate jobs in the US right now are in North Dakota, so long as you don’t mind living in a trailer) and in associated industries such as rig engineering and construction. In contrast to consensus IB forecasts, the EIA also expects increased US production to put downward pressure on oil prices, with Brent crude dropping from a record average of $112 per barrel last year to $99 in 2014.

US crude production fell to just 5m bpd in 2008, but rebounded to 6.43m last year and is expected by the EIA to rise to almost 8m in 2014. At the same time, consumption has been falling, from 20.7m b/d, for all liquid fuels, in 2007, to 18.7m last year. The EIA expects that the US will still use less oil in 2014 than in 2011, as conservation efforts (notably a far more fuel efficient car fleet) pay dividends. The surge in production in the US has led some forecasters, including the International Energy Agency, to predict that it will overtake Saudi Arabia and Russia to become the world’s largest oil producer by the end of the decade. The EIA has been cautious about endorsing the more euphoric forecasts, which depend on factors that are difficult to predict including Saudi production spare capacity growth, stability in Iraq etc. The US will still next year be importing about as much oil as at the time of the shocks of 1973-74, and even if the US becomes completely self-sufficient in oil, it will not be able to ignore the potential threat to the world economy created by price rises and supply disruptions, and so would still have an interest in sustaining production in the Middle East.

In the 15th November weekly, I noted that: Coal’s share of total US electricity generation has dropped by more than 10% in the last four years, replaced by NG. And US coal production this year is expected to drop by 7%, despite surging exports, notably to Europe. Dirt-cheap NG prices have caused a major slowdown in drilling activity, which will help ease the supply glut that has plagued gas producers during the past several years, and is reflected in a 25% price jump in recent months while thermal coal languished below $80/tonne. The switching terms from coal for US power plants, having been compelling, have reversed since then. Added support comes from power demand bottoming in China.’ The US Energy Department forecasts that the average spot price of natural gas will hit $3.68 in 2013, making current thermal coal prices highly competitive for power generators while China looks set to import 240-50 million metric tons of thermal next year, or 10% more than in 2012 at a time when the US exportable surplus is shrinking.

Since the end of October, benchmark prices have risen around 10% with thermal coal from South Africa’s Richards Bay trading at $88 a ton.  Although China’s immediate appetite for coal may be muted with above average stockpiles, prices should be buoyed by seasonal restocking across the Northern Hemisphere in coming months. The price for top-grade coal should break $100 a ton by end Q1, and indeed an average thermal coal price of $100-110 a ton for 2013 is feasible, from recent lows sub $80.

Resurgent North American oil production is finally being matched by increases in pipeline capacity, releasing ‘trapped’ domestic supply onto the global market. As shale oil production surges, drillers and refiners have used trains, barges and trucks to move oil from remote mid-Western fields to coastal refineries but all are more expensive than pipelines. The Association of Oil Pipe Lines estimates that new US pipeline capacity totalling 500,000 bpd came into operation last year while US crude output rose 780,000 bpd. It’s a good bet that the WTI-Brent price gap, which has been running at $20-30 in recent months, will close toward $10 over the next 12mths or so. The new Seaway pipeline is set to almost treble capacity from Cushing, Oklahoma, the delivery point for WTI oil futures contracts, to the Gulf of Mexico export terminals, helping drain record stocks at Cushing, which have artificially depressed the WTI price.

Meantime, while gasoline prices dropping about 50c a gallon in recent months are a discretionary spending windfall for US consumers, broad credit and money supply trends in the US also remain supportive, with three month moving average growth of just sub 6% in total bank credit and over 8% in commercial and industrial loans. We’ve also seen four straight months of impressive gains in overall consumer credit. Consumer credit increased more than forecast again in November, led by borrowing for student loans and auto loans; the $16bn gain followed a $14.1bn advance in October. With sustained if modest gains in the labour market and strong demand for student loans and autos, consumer credit should grow further in Q1. Easing bank lending standards combined with an improved labour market suggests that consumer spending can withstand the 2% payroll tax hike from the fiscal cliff deal.