‘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. 

Has US Healthcare Inflation Peaked?

The soaring cost of healthcare in the US over the past 20 years has been a hugely distorting economic trend as a key driver of personal bankruptcies, by depressing private sector wage growth as employer insurance bills surged and absorbing 17% of GDP or about twice the developed economy average. Are we at an inflection point? Among the various measures of healthcare inflation in the US, the broadest is the BLS calculation of the cost to private sector employers of providing healthcare benefits, now down to 2.4% y/y, the lowest since 1981. A recent survey by payroll processor ADP on the rise in medical insurance premiums paid by large employers has tumbled to 1.7% y/y.

‘Obamacare’ has certainly boosted transparency but technology seems to be finally suppressing healthcare inflation in the way it has in so many other sectors; doctors and nurses now routinely carry tablets to take patient notes, cutting out layers of administration and overlap. ‘Diagnostic algorithms’ are now entering common usage, so much so that the nurses’ union is conducting a media campaign with the punchline “Algorithms are simple mathematical formulas that nobody understands.”Well the geeks in Silicon Valley certainly understand them and investors are slowly waking up to the implications of ‘deep automation’ software spreading across the service economy.

Robotic pharmacists are already being introduced at some hospitals and the Food and Drug Administration has issued a patent  for the first ‘human interacting autonomous robot’ for medical use, mirroring developments in Japan. The RP-VITA robot allows specialists anywhere in the world to communicate with patients, has data ports that connect to digital thermometers, stethoscopes and ultrasound imaging as well as integrating medical records. Meantime, the explosion in wearable monitoring equipment for vital data from Apple, Nike etc. will eventually be integrated to deliver pre-emptive healthcare intervention. The best doctors will be freed from mundane patient diagnostics but like the London taxi drivers protesting against Uber’s arrival which I covered recently, their mediocre peers and those relatively well paid nurses will see their wage premium steadily eroded. 

That has huge implications on a macro level; firstly, healthcare was the single largest source of aggregate private sector earned income growth in 2000-2009 and it’s hard to see what replaces it; secondly it was the major service sector contributor to CPI growth (alongside college tuition and the associated $1.2trn student debt burden, a sector also vulnerable to tech disruption) and if this downtrend continues, again it’s hard to see what replaces it. Lastly, healthcare costs were the major driver of the long-term structural deficit in the US (via Medicare/Medicaid entitlements) with total spending until recently projected by the CBO and other independent analysts to top 20% of GDP by end decade – a sustained fall in healthcare inflation has dramatic implications for the equilibrium rate for USD (higher)/bond yields (lower)/US fiscal deficit (lower). Indeed, medical spending accounts for 17% of the Fed’s preferred personal consumption (PCE) inflation measure and the slowdown in healthcare inflation means that sustaining the 2% target rate medium term (equivalent to 2.25-2.5% CPI) will be difficult, partly explaining this year’s ‘surprise’ Treasury rally, although investor repositioning from a bearish duration consensus and ECB easing expectations also played a major role.

Tech trends are net bullish for emerging markets as an asset class by allowing development to ‘leapfrog’ infrastructure/human capital constraints but the macro impact on long-term developed world inflation/interest rates/employment market ‘slack’ is still widely ignored as economists stick to their orthodox models. Indeed, that is the basis of predicting a classic if belated wage and investment cycle as the capital stock is getting old, funding costs are at record lows, the utilization rate is climbing to pre-crisis highs etc. That’s all fine in so far as it goes, but of all the investors I talk to, tech VC people seem to understand the wider economic implications of the disruptive business models they’re investing in best. US capex trends YTD remain weak and the core orders segment of the April durables goods data sustained that trend. While there will be some belated cyclical pick-up, we’re almost certainly seeing a structural down shift in investment intensity in GDP and revenue growth as technology related capital goods which have a strong deflation price trend become a bigger share of overall spend. As noted previously (and in stark contrast to Japan and EM) S&P buybacks plus dividends exceeded capex last year, although institutional surveys suggest most US investors now want to see companies ramp up investment.