Huawei Quarantine Accelerates Tech ‘Balkanization’ Trend

“The three core issues of concern to China are the cancellation of all tariffs, that trade purchases be in line with reality, and that the text of the agreement be revised so as to be more balanced. These issues must be resolved. This trade friction has made us more aware that we have shortcomings in terms of economic structure, quality of development, and core technologies. [We must] enhance the sense of urgency in accelerating indigenous innovation and resolve the bottleneck imposed by insufficient mastery of core technologies. CCP Propaganda Department Commentary on the US confrontation in People’s Daily newspaper last Friday

We have regularly covered the rise of China’s tech sector over the past decade and the complacency in Silicon Valley which has only recently been shattered by Huawei’s threatened dominance of the global 5G rollout. The ‘balkanization’ trend already evident in software ecosystems from messaging to payments will now extend to hardware throughout the supply chain – there will be a China centric physical internet architecture over the next decade centred on Huawei as much as a software one around companies like Alibaba, Tencent and Bytedance with the big ‘neutral’ EM markets like India a key battleground.

In the near term, the notion that China can be quarantined as a technology supplier looks naïve – alternative vendors like Nokia and Ericsson make 5G hardware with Chinese partners in mainland factories for sale globally, leaving their equipment vulnerable to malicious tampering – will they have to relocate production to ‘safe’ locations to sell into the US? If so, the global rollout will be significantly delayed…

Huawei has been rapidly vertically integrating with its own chip making subsidiary, HiSilicon, producing highly advanced 5G designs, albeit fabricated (as for Apple and Google) by TSMC. As a Chinese tech VC contact told me in Shanghai last October, cut China off from TSMC and it would be casus belli like the Japanese oil embargo in 1940. If the US is serious about confronting China’s competitive threat on a sustained basis, it needs to boost government R&D spend on basic science (instead it’s been cut), deepen the capacity of domestic tech supply chains via education investment and targeted tax credits or cutting off broader Chinese access to advanced GPU chips and postgraduate student access to STEM courses at colleges such as MIT and Stanford. Those moves would be expensive and disruptive for the US economy and are still possible future steps if relations become even more antagonistic.

China offers uniquely low (marginal) consumer electronics assembly costs plus high-volume flexibility. You can never replicate the mainland factory dormitory model in the US or even Korea and Taiwan. The increasingly well educated rural migrants filling Foxconn factories are the ultimate ‘on demand’ workforce – manufacturing elsewhere would mean higher assembly costs/decreased flexibility thanks to the constraints of current generation assembly line robotics.

Even with high levels of automation, a fully US assembled iPhone would likely cost about 40% more at the factory gate (with Apple gross margins at ~37%, the current tariffs imply a price rise of about 15% to offset the impact, unless the RMB plunged toward 7.5 versus the USD). For instance, Quanta Computer, the largest laptop maker in the world with clients from Apple to Dell, warned last week that the logistical costs of shifting consumer electronics production out of China could prove as expensive as the tariffs themselves. 

Automation is part of the answer to offshoring from China but changes the business model – assembly by Chinese migrant workers is a marginal cost for a factory owner; robots are a fixed cost, although the assembly of an additional unit has zero marginal costs (excluding overheads like maintenance etc.). New AI software will help but it’s still expensive and time consuming to program factory robots to perform multiple tasks.

The implication of this shift from marginal to fixed costs is that there is a heavy incentive to stick with a specific design: any change requires significant capital investment to update the robotic assembly line – the flexibility of the entire consumer electronics sector will deteriorate, with higher inventories and fixed overheads once it loses China’s unique attributes as a global production base – given wafer thin margins, consumer prices will trend higher even if a face saving deal could avoid further tariffs.

Relocating the supply chain for smartphones or laptops will be hugely disruptive, wherever the destination and it certainly won’t be the US – the much-hyped Foxconn factory to make TV screens in Wisconsin has become a fiasco, despite $4bn in tax breaks and subsidies. The lack of a skilled manufacturing workforce will be a key constraint on US re-shoring, as much as logistics considerations – flying components in from Taiwan/S. Korea to assemble phones in the US makes little sense.

The effort to lobotomise Huawei looks ill thought out and will have generated intense lobbying by the most adversely impacted US suppliers – there will likely be some nuance in the implementation. However, the endgame is now clear and US tech companies will have to mitigate ongoing compliance risks by reducing exposure to Chinese SOEs. We’ve seen a few companies like Go-Pro begin relocation (to Mexico in this case), but this will now accelerate while China will race to become a ‘full stack’ technology power by mastering semiconductor fabrication and an indigenous mobile operating system.

In the case of both Iran and Huawei, the US has unilaterally exercised its global power over international bank payments systems and key technologies like the Android OS to exercise brute force geopolitical leverage – the lesson drawn by many in Europe and Asia is that alternative architectures are now needed. Ultimately, China which remains the only country apart from the US to understand the critical value of ‘platform’ software and is catching up rapidly in AI and quantum computing research, will become an even more formidable competitor to the US tech giants. The Xi 2025 plan, whose ambitions triggered panic in Washington from the Pentagon to Congress, will now be implemented sooner, by any and all means possible.

 

‘Peak Smartphone’ Slams Tech Hardware

‘…we are reaching ‘peak smartphone’ and the upgrade cycle is lengthening as new features prove less than compelling – the mobile app landscape has certainly become stagnant. Heavy discounting of the Samsung S8 ($150 plus) is apparent already in the US and the recent profit warning by the UK’s largest phone retailer highlighted a consumer behavioural shift. While the hype cycle will intensify ahead of this month’s launch of a premium advanced OLED screen model with facial recognition security, if the queues outside Apple shops for the new iPhones prove surprisingly short (or short lived), watch out below.’ Weekly Insight, September 6th, 2017

‘The ‘Peak Smartphone’ theme justified an underweight stance back in Q4 across the most heavily exposure Asian supply chain stocks, with DDR4 DRAM prices down about 20% from its January peak and NAND flash down a third. Many DRAM bulls put premature faith in AI and AVs as incremental demand drivers, certainly valid medium term, but not on a scale to offset smartphone/PV weakness this year while for chip makers the end of the crypto mining frenzy is starting to impact. TSMC said this week that sales will rise by only a ‘high single-digit’ percentage in USD terms, down from a previous (reduced) projection of 10%.’ Weekly Insight, July 20th 2018

The smartphone saturation risk we covered over a year ago has gone mainstream and rippled through the global hardware supply chain, with NAND flash prices crashing this year, DRAM also now peaking while production volumes for premium new phone models have disappointed across the sector. It’s hard to believe that most tech analysts missed this pretty obvious inflection point, when even the IMF noticed the industry had topped out as an Asian growth driver (smartphone shipments were about a sixth of global trade growth last year), but mindless extrapolation of the prevailing trend remains the default setting of bottom up analysts.

Smartphones have seen little innovation beyond camera quality and biometric security since 2016; the lack of compelling new hardware features (or new apps requiring them), and the growing ‘digital detox’ trend as awareness of the adverse productivity impact of notification addiction rises have both dragged on demand growth. Tighter network upgrade policies as well as limited ‘must have’ innovation have seen US and European consumers replacing phones every 2.5 plus years, a rise of 7-8 months since early 2016.

As we highlighted a year ago, the refurbished market has seen explosive growth and was the fastest growth segment last year, reaching over 140m units and is still growing at a mid-late teens pace. Three-year old ‘as new’ iPhones and Samsungs have been flooding emerging markets at typically a third of the price but nearly all the functionality of new. The weak outlook was confirmed by several Apple suppliers this week including Lumentum, Japan Display and UK chipmaker IQE this week – Apple as a ’luxury’ tech brand has finally succumbed to wider sector dynamics, although higher ASPs and the shift to services mean that the component supply chain takes a bigger hit.

Until 5G rolls out at scale from 2020 (and compelling new use cases beyond watching Netflix on the move have yet to appear), it’s hard to see the wireless sector regaining much impetus. While Samsung and Huawei plan foldable screen launches next year, initial volumes are likely to be modest at a price point above $1,000. Valuations now certainly look far more reasonable and expectations more realistic, but the downgrade cycle looks set to run into Q1 19. Our view remains to focus exposure  on stocks with high exposure to the nascent autonomous vehicle/automation sensor and emerging consumer segments such as smart speakers.

However, there will be an opportunity in the 5G rollout in niche areas such as high-end optical chips/dark fibre as well as smart antennae. Chinese producers will have a head start and gain critical mass, as the country embarks on the telecom equivalent of the hugely impressive high-speed rail network, which I used several times on a research visit last month. There will certainly be opportunities in China for specialist foreign vendors like Nokia, but the ‘full strength’ 5G being implemented via a new national core network is a critical component in the effort to drive domestic suppliers up the hardware value chain, in both phones and wireless infrastructure.

Facebook Debacle to Accelerate ‘Self-Sovereign’ Privacy Innovation?

We highlighted coming into 2018 that investors faced an inflection point in the ‘zeitgeist’ for US web stocks, which have been engaged in a form of classic rent seeking and regulatory arbitrage as they built natural monopolies in which the user is the product. We have been secular bulls on global tech over the past few years (although broadly preferring the Chinese to US internet names since 2015 on more diversified business models) but the blind faith of some portfolio managers I’ve met this year has seemed almost cult like. At one meeting last month, an investor whose biggest single holding (in a value fund) was Facebook informed me after an hour of debate that Zuckerberg was a business genius who would prove our bearish thesis wrong, end of.

Perhaps, but he’ll have to do better than the self-servingly sanctimonious ‘building a community’ mantra to restore user and more advertiser faith. Of course, even if revenue growth and margins now almost certainly disappoint, Facebook is at least highly solvent and cash generative. Tesla isn’t without a significant capital infusion by end summer and is still struggling to scale up manufacturing, as evidenced by the disastrous Model 3 launch. The last car so badly built in the factory that it had to be effectively reassembled by dealers was the Soviet Lada, exported to Europe to earn hard currency in the 1980s. At least the Russians could knock out (literally) serious volumes.

Our tactical portfolio has recently been short the US web names, even as tech-focused stock funds have attracted net inflows equivalent to half of those seen in all of 2017. The almost viral, social media inspired retail frenzy that infected crypto in Q4 moved on a handful of leading tech names despite extended valuations priced for execution perfection. Just as belated regulatory action has slammed the crypto sector, so it will for several leading web names. The end of crypto and ICOs as an advertising revenue stream for Google/Facebook is a risk to H2 numbers as it will be for the GPU chip names as coin mining approaches marginal profitability.

There is no question that companies such as Microsoft retain strong earnings momentum (and Microsoft’s ‘software as a service’ reinvention via Office 365 cloud subscriptions etc. has been mirrored by many other legacy software names such as  Adobe). There are plenty of attractive themes in tech but the vulnerable areas to an investor exodus are those with unsustainable business models. and extreme positioning. It’s now widely accepted that ‘weaponized AI’ was used to micro-target voter groups based on interpolating preferences from their social media activity in both the US Presidential and Brexit votes, but intrusive data trawling looks far more widespread than yet realized, including via Android phone records.

I’ve compared social media in research notes to digital nicotine or casino gaming, with the adverse addictive fallout only now becoming apparent. However questionable ethically, until now this activity has remarkably remained almost wholly unregulated. Indeed, the same psychological design features that casinos use in slot rooms to maximize ‘time on device’ and engagement are embedded in multiplayer games, Facebook timelines etc. As that view of the negative externalities becomes widespread, ESG investors will likely begin reducing exposure.

Just the threat of regulation will drive up compliance costs which will be a medium-term earnings growth drag (the employment of thousands of outsourced ‘screeners’ over the past few months checking for offensive content to appease advertisers is just the start). The aggregation effects that fuelled social media/search and e-commerce platforms drive natural oligopolies if not monopolies, albeit with market power difficult to identify within a classic consumer welfare anti-trust framework.

Facebook was misunderstood in the sense that it was an inherently weak business model than the consensus believed in just how much relevant user data it could collect directly for advertisers. Unlike say Google, that forced it to rely on elaborate inference to discover user tastes and needs. It had to collect, share and ‘harvest’ as much behavioural and relationship related user data as possible beyond its own network via its Graph API partnerships until 2015. Most users when they agree via a single click to the complex disclaimers on apps simply can’t understand the implications of the agreements they are entering into and as with sectors from banks to airlines, consumer protections will now gradually be legislated, with the EU’s GDPR rules from May the first step.

With personal data privacy now becoming a priority for many, ‘self-sovereign identity’ systems are emerging to make it easier to take back control. These imply that individuals control the data elements that form the basis of their digital identities, not unaccountable private companies. This digital equivalent of a wallet contains verified pieces of our identities (passport, biometric etc.) which we can then choose to share with third-party apps and sites on a selective basis. This type of online identity uses standard key cryptography,  enabling a user with a private key to share information with recipients who can access the encrypted data with a corresponding public key.

By allowing individuals to control their online reputation and privacy, self-sovereign identity may ultimately become the most valuable and widespread blockchain application and would make it much harder for data hackers (or harvesters) to access sufficient data to interpolate income level, political beliefs etc. That would erode the business model of the ‘Apex Server’ web giants, but for software companies not based on stockpiling user data, decentralized identity should be a boon for customer acquisition and management.

In a recent blog post, Microsoft announced that it would start supporting decentralised identification technology within its existing verification application. Apple is also likely to take advantage of Facebook’s humiliation with a privacy focused product – its iOS phones have been immune to Facebook’s trawling of SMS and call records on Android devices for close contacts on the social network. Indeed, tech investors need to start thinking of data privacy winners and losers across the sector in a regime shift for the Silicon Valley ‘consumer as the product’ advertising led revenue paradigm. 

Tech Driven ‘Creative Destruction’ Remains Key Global Trend…

‘Admittedly, during the First and Second Industrial Revolutions the magnitude of the destructive component of innovation was probably small compared to the net value added to employment, NNP or to welfare. However, we conjecture that recently the new technologies are often creating products which are close substitutes for the ones they replace whose value depreciates substantially in the process of destruction.’ New NBER paper on the latest wave of technology driven ‘creative destruction’

Academic economists are beginning to wake up to the macro implications of the accelerating digitization and dematerialization of the global economy, which has been a key structural theme both in terms of its impact on interest rates, inflation etc. but also portfolio weightings – earnings power across many established sectors will be destroyed by new entrants, who will see earnings explode even as they offer services at a fraction of the cost of incumbents e.g. instant messaging versus SMS revenues. The point the study is making is that unlike previous disruptive cycles (the industrial revolution from the mid-19th century, the first IT revolution from the 1970s) much of this mobile/cloud based service innovation destroys value within the overall economy to the extent that there is a net loss of profits, jobs etc., a topic I’ve covered recently in notes looking at deep automation/robotics and the sharing economy trend. However, one thing I’d note is that nearly every tech innovation of recent years from instant messaging to social media has been initially dismissed as trivial, but that ignores the huge impact of rapidly scaling network effects in creating utility for consumers and market value for investors. The value of LinkedIn or WeChat to users lies in the critical mass of peers they offer access to and the value to investors is the near zero marginal cost of adding new users. There are certainly too many mobile messaging services and the sector in aggregate is overvalued, as highlighted in previous notes, but the opportunity for the winners to take revenue from the established offline media and financial services sectors remains compelling. Against this secular backdrop, the NASDAQ Internet Index hasn’t quite regained its March peak but is 20% above the low set in early May after a brutal selloff as momentum positions unwound; the US Biotech Index, which led the momentum stock selloff in Q2, has broken out to a marginal new high and is up almost 30% from its mid-April low. Analysts have been upgrading their earnings estimates for the Biotech sector, with earnings now expected to rise almost 40% this year.

Meantime, Facebook, Google, and Twitter all reported above consensus results for Q2 and forward earnings for the internet sector have risen to a new record with about 20% compound earnings growth expected across the sector over the next few years. Chinese web stocks have generally continued to beat expectations from Tencent to Alibaba, the former driven by mobile gaming leveraging the 350m WeChat user base and the latter by mobile e-commerce, with active users up to 188m in Q2 and mobile up to almost 33% of gross sales volume. I noted in the 10th September note last year on the sector that: ‘China’s combined dominance as a smartphone market and manufacturing base has very bullish implications for domestic web software and service companies. For software companies from Google to Microsoft, smartphones are simply the platform for profitable content delivery. The value of content consumed on Android devices will explode in the coming years, starting with ‘in -app’ click through purchases in games and ads viewed while browsing, but smartphones will become the terminal of choice for e-commerce and the decision point for offline retail purchases too.’ Alibaba’s float is likely to drive volatility in smaller Asian tech sector names as portfolios reposition to fund their allocation, particularly as the internet sector has regained its Q2 losses, but it’s hard to see Alibaba generating the 13x 10-year returns of Google which was a very misunderstood business model at its $95 IPO price. For non-benchmark huggers, there will be a tactical trading opportunity in the wider Chinese tech ecosystem over the next couple of months – the secular outlook for the digitization of the Chinese and other EM economies remains very bullish. On that note the more modest but still multibillion float of e-commerce start-up incubator Rocket Internet bears watching. It’s an odd company which has been accused of ‘cloning’ established online business models, with its hugely well-funded operations led by former management consultants rather than entrepreneurs and little of the typical Silicon Valley start-up culture. Nonetheless, it has established leading positions in e-commerce markets across ASEAN, which ex Singapore are several years behind China in terms of development but will catch up rapidly as smartphone penetration rates rise and mobile payment systems mature.

Social Media Giants Battle for Mobile Dominance…

“The competition in mobile and the social space intensified. It is imperative that we increase our market space in mobile in order to stay competitive.” Sina Weibo’s CEO this week, echoing Facebook’s dilemma

“Party like it’s 1999…” Prince, who unwittingly wrote the anthem to the last tech bubble

I’ve been consistently overweight tech over the past year as a beneficiary of relatively scarce revenue growth momentum and global excess liquidity, as well as several new innovation driven growth cycles. Back in a note covering the ongoing upside for China’s social media giants last September, I highlighted that ‘…there is no question that we are now seeing similar global investor excitement over the potential of the mobile internet as the original PC based model back in 1999.’ The social media sector is essentially a smartphone screen ‘land grab’ at this stage with relatively low barriers to entry, and in investment terms a global momentum trade until clear winners emerge and/or overall customer acquisition growth rates peak – it’s dangerously late to chase the theme. Many fundamental investors understandably recoil from social media/mobile web valuations, but these companies will eventually be value destructive across huge swathes of a blue chip equity portfolio, as consumers shift their media and retail consumption as well as financial management to the mobile device, and revenues follow them. For the moment, investors in this exponential growth sector think less about fundamentals to focus primarily on numbers of users, their growth rate and engagement with the service as indicators of potential future revenues, as detailed below. In other words, ignore them at your peril as a force for classic technological ‘creative destruction’.

It is very likely that the market is over estimating the value of users at social media companies in aggregate, as many brands will fall by the wayside like fallen web giants (and early movers) MySpace or AOL over the past decade. As social media companies move up the life cycle, the variables to price companies will change from number of users/user intensity to revenues, earnings and cash flows. When that happens, there will be a repricing of social media companies, with those that were most successful in turning users into revenues/earnings being priced higher. The problem for companies (and investors) is that these transitions happen unpredictably and that markets can shift abruptly from focusing on one variable to another. For Facebook, the path to success with this deal is therefore simple, albeit not easy. Start by trying to attract Whatsapp users to the Facebook ecosystem, and hope and pray that the market’s focus stays on the number of users for the near term until you can monetize them in some sustainable way, and the user churn rate in these services is likely to be very high.

Facebook paid 11% of its market value, or approximately 35% of cash on hand and nearly 10x the company’s 2013 free cash flow for WhatsApp, which is worth more to Facebook than it is on it own because the competitive threat from mobile messaging services could cause a significant decline in Facebook’s valuation if the company didn’t act – they’re pretty good at game theory in Silicon Valley. If say WhatsApp gets to a billion users and it continues to charge them only $1 per year, that implies well over $600m in operating income, given that the only material costs are likely to be the 30% app payout to Google and Apple. That incremental EPS largely offsets the deal dilution. If Facebook has significant competition, and its acquisitions of Instagram and WhatsApp and the attempted acquisition of Snapchat signify that it believes it does, it’s hard to justify Facebook’s current valuation on a standalone basis, and using that high priced stock currency to pre-empt competitive threats, even in their start-up infancy, makes sense for the US tech giants (as Google has done recently with the UK’s DeepMind), although it will ultimately strangle innovation and deliver some form of cartelization of the internet.