Smartphones: The Market is Mature – Now What?

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October 18, 2019

Smartphones: The Market is Mature – Now What?

The 5.1B global mobile phone installed base has plateaued. New phone sales turned down over the past two years as users have replaced their phones less frequently. Forecasters optimistically look for a return to growth in 2020, but we are skeptical – 5G networks are not quite ready and the innovations offered in the latest flagship smartphones too incremental and uninspiring to reinvigorate the upgrade cycle. In this environment, the growth in the smartphone ecosystem is coming from services and peripheral devices, and the contrast in philosophy and strategy between the leading platform players is stark. On one hand, AAPL views the iPhone as the indispensable center of a user’s universe with a meticulously managed ecosystem of services and associated products extending its value. This reflects in the rigid control of the App Store and the exclusivity of the company’s services and peripherals to the iOS platform. In contrast, GOOGL (and AMZN and Tencent) see the smartphone as the most popular portal to access a suite of services that should be available from any connected device. We believe that “ambient computing” model has intrinsic value to users – consistency, flexibility, computing power, etc. – while the “walled garden” approach is limiting and at risk to legal and competitive disruption. Still, the much greater control over its ecosystem should be a significant asset for AAPL as the platform players move into more complex solutions sets, like healthcare and financial services. For now, we are cautious for stocks that are levered toward smartphone device sales (AAPL, QCOM, Samsung, etc.) and favor those focused on services (GOOGL, AMZN, etc.)

  • Mobile phones are a mature market. The installed base of mobile phones has stagnated at just over 5B. Sales of new devices into this base have declined in each of the past 3 years, driven by lengthening upgrade cycles abetted by a robust used phone market. Within that market, basic smartphones continue to take market share from both cheap feature phones and premium smartphones, consistent with the falling price of basic smartphones and from an installed base shift toward emerging economies.
  • Device upgrades have stalled on weak innovation. Since AAPL’s large screen iPhone 6 lured throngs of its small screen users to accelerate their phone upgrades in 2015, consumers have stretched out the lives of their smartphones longer and longer. Higher prices and the loss of carrier subsidies were factors, but the biggest driver seems to be a lack of compelling innovation. Cameras and processor speeds were already good enough before improvement, while features like Face ID, AR, and wireless charging failed to generate excitement. This year, the newest flagship models once again feature incremental enhancements rather than ground-breaking innovation. We do not expect this to spur meaningful change in upgrades without a substantial reduction in price.
  • 5G is coming but won’t help until 2021. The first 5G smartphones have hit the market, but they are unlikely to be more than a small piece of 2020 demand. At first, the only benefit to consumers will be ultrafast connections limited to specific hotspots in a few of markets. This may be less beneficial than many presume, as connection bandwidth is only one factor in performance – network latency and server congestion are equally important bottlenecks. Consistently improved performance and new applications (e.g. multiplayer fast-twitch gaming, AR, etc.) exploiting the lower latency and flexibility of the standard will only arrive as 5G coverage expands and becomes denser in later years. Moreover, the first 5G devices will be expensive and relatively bulky, further barriers to adoption. Like the standards before it, we expect 5G adoption to really take off more than a year after the initial launch.
  • Device-first or Services-first? Services delivered to mobile devices are a huge and rapidly growing industry, roughly split into 4 main areas: Content – media, social networking, games, etc. delivered from the cloud and monetized via ads, subscriptions and one-time fees; Commerce – platforms for selling goods and services; Tools – utilities (e.g. search, maps, photo management, wallets, etc.) monetized via ads, fees, links to other paid services, or as lock-in to a platform; and Gateways – apps to facilitate the delivery of complex consumer services (e.g. healthcare, financial services, transport, etc.). AAPL views services as subsidiary to its device business, using its own offerings to lock users to its platform and demanding substantial fees from 3rd parties looking to access its installed base. In contrast, GOOGL, along with AMZN and Tencent, sees devices as portals to its services, which are to be delivered as widely as possible across any platform that will allow it.
  • Peripherals or Alternative Access Devices? AAPL’s biggest recent innovations have been in peripherals, with the Apple Watch now a $5B+ product and the popular AirPods prodding a wave of copycats. Critically, AAPL’s products only deliver their full functionality if paired with an iPhone, intending to enhance the experience for AAPL users and to raise their annual spending on AAPL products. In contrast, its rivals see devices like smartwatches and AI connected earbuds as added distribution that can increase engagement for lucrative services like GOOGL Search, YouTube and Maps or AMZN shopping. As such, the devices are not brand exclusive, even looking to break into the iOS walled garden. Indeed, smart speakers, a fast-growing category pioneered by AMZN, operate entirely separate from the user’s smart phone, as do video streaming devices, like ROKU, AMZN’s Firestick or GOOGL’s Chromecast. As such, AAPL has largely stayed on the periphery. We believe all these access devices have significant further runway.
  • Threats to the Walled Garden. SCOTUS has ruled that AAPL must defend its App Store on anti-trust grounds, challenging about a third of its nearly $40B TTM services revenue. This likely portends similar scrutiny in the EU and other markets, and dovetails with moves by popular content apps, like NFLX and SPOT, to shift their monetization outside of AAPL’s purview. We also note that AAPL’s device centered approach hamstrings the functionality of some applications which do not maintain consistency outside of the AAPL ecosystem, and in some cases, between different AAPL devices. Longer term, we see these as substantial unacknowledged risks.
  • Services and Alternative Devices in 2020, Not Smartphones. We believe that the replacement cycle is unlikely to turn until 2021, when 5G will become more relevant to most markets and across price points. Companies levered against these devices – AAPL, QCOM, GLW, Samsung, TSM and others – are at risk of near-term disappointment. Wait until next year. Companies that skew toward smartphone delivered services or to alternative devices – e.g. GOOGL, AMZN, and many others – are better positioned for the next 12-18 months.

Phones and Other Devices

There are more than 5.1B active mobile devices on earth, a count that has settled into <1% annual growth as population and the economic tide make new users viable. About a third of these users bought new devices in 2018, a trajectory that has slowed as annual unit sales have slid into decline. Of the reasons for the lengthening replacement cycle – higher prices (especially for premium products), the end of carrier subsidies, growth of the robust used phone market, etc. – the most important is innovation. In the past few model years, the primary device improvements have been incremental – better cameras, faster processors, etc. – without meaningful use case innovations or design changes to really spur upgrade demand.

2019 has been the worst year yet for phone makers, with unit volumes projected to drop nearly 4% YoY. Still, hope springs eternal and industry forecasts project an abrupt turnaround for 2020, with growth driven by the new 5G network standard. We are skeptical. The latest flagship devices offer nothing to excite users to replace their still perfectly adequate 2 or 3-year old smartphone. Yes, the first 5G models are here, but the narrow coverage of the first networks deployed in just a handful of markets limit the potential for a game changing stimulus. Moreover, those first phones will also be expensive and power hungry, offsetting the marginal benefit of faster connection speeds in those occasional 5G hotspots. Indeed, AAPL has declined to offer 5G for its 2020 model year. We see 2021 as a more realistic kickoff for 5G replacement cycle acceleration and project device sales flat to down for a 4th consecutive year in 2020.

Of late, AAPL has been emphasizing their growing service revenues, while GOOGL’s Android strategy has been to drive usage for its portfolio of cloud-based platform services. We break services into 4 categories, Content (streaming media, games, etc.), Commerce (shopping, etc.), Tools (search, maps, storage, etc.), and Gateways (platforms for healthcare, personal finance, etc.). Obviously, huge internet businesses now rely on mobile platforms – AMZN, FB, GOOGL, BKNG, etc. – but these franchises spar with mobile platforms (iOS, Android, WeChat) for control and monetization, as the platforms take distribution fees and look to offer proprietary, integrated alternatives. We believe that platform domination of services distribution could come under significant pressure, both from regulators focused on app store monopolies and from franchise operators shifting monetization away from reach of the platforms. Nonetheless, we see substantial further upside for service applications, funded by ads, subscriptions and fees, as the tug-o-war plays out.

Peripheral devices are a bright spot. AAPL made smartwatches into a $5B business growing at a 40%+ annual pace, dragging along products from Fitbit, Samsung and others. We are concerned that the market is limited to a modest subset of smartphone users, even amongst the well-heeled and loyal AAPL base, but the inevitable slowdown still looks years away. Second, AAPL’s Air Pods smart earbuds pioneered another exciting category, one that we believe offers even more potential than watches. Here AAPL has left the door open without update since the 2017 launch and the ho-hum performance of its Siri AI assistant. New products from AMZN, GOOGL, Samsung and others could leapfrog the now venerable Air Pods. Finally, AI speakers/hubs are showing a lot of staying power, tying to online service franchises like AMZN’s e-commerce and GOOGL’s Search, Photos, YouTube and others. As the big platform players (GOOGL, AAPL, AMZN) move to address more complex services (e.g. healthcare, financial services, transportation), these home-based access points could be crucial access points.

A Smartphone in Every Pocket

37 years after the first commercial cell telephone hit the market, there are more than 5 billion mobile devices in use (Exhibit 1). The large majority of these are smartphones, the result of nearly a decade of hypergrowth in the category after the 2007 intro of the iPhone. That dynamic drove much of the value creation in TMT in the first half of this decade, taking Apple to top of the list of the most valuable companies on earth. Then, after the stunning success of the iPhone 6 and its long anticipated large screen format and the introduction of Android models below $100 drove double digit growth in 2015, the brakes came on in 2016 as unit sales growth dropped below 4%, the start of 4 years of lackluster demand.

The biggest factor for the slowing mobile device sales growth was the stagnation of the installed base. Globally, the base hit 5 billion in 2016 but has inched along since then, reflecting the near saturation of all but the poorest demographics. Manufacturers squeezed a bit of growth from pricing as the basic cell phone market gave way to the low-end smartphone, and as Apple led the premium category with price jumps in both 2017 and 2018. Still, a turn to declining market sales in 2019 suggests that price elasticity may no longer be working in favor of those top brands (Exhibit 2, 3, 4).

Exh 1: Global Mobile Installed Base and Forecast, 2017 – 2023E

Pricing has also contributed to users holding onto older phones for longer, as has the near universal end to carrier subsidies on new phone purchases. However, three years into a declining market it seems clear that the biggest factor is a lack of compelling innovation. Those big screens, first on Samsung phones, then

Exh 2: Global Smartphone Unit Shipments growth has declined, 2010 – 2019

Exh 3: Smartphone ASP has partly offset dropping unit sales, 2013 – 2019

Exh 4: Global Mobile Phone Unit Sales Forecast 2017 – 2023E; all expansion will come from the non-premium segment

copied by every other Android licensee, and finally and begrudgingly adopted by Apple in in 2015 were the last new feature that really got the fanboys lining up outside the Apple Store and everyone else waiting for availability. Since then, the style of premium phones has remained largely unchanged and annual improvements have been either incremental – like better cameras, faster processors and higher screen resolutions – or largely ignored – like FaceID and ARKit. A three-year-old iPhone is still a pretty good product and if it ain’t broke, don’t replace it, at least not for $800 or more.

So, the global base of phone users has plateaued and consumers who used to upgrade their smartphones every year or two are keeping them longer. In 2017, 36.3% of phones in use were replaced by new devices. In 2018, that fell to 35.5% and in 2019, the metric is projected to drop all the way to 33.8% (Exhibit 5). This is a bad equation for phone makers, including Apple, which has seen declining unit sales for two years. At first, price hikes allowed sales to go up even as units declined, but by 2019, that mojo is gone. With half a year of data, industry forecasts now project total mobile phone unit sales off nearly 4% this year, with the premium smartphone segment down 4.2% after a 3.6% drop last year. The trajectory is not attractive.

Exh 5: Annual smartphone replacement rates are declining, 2017 – 2023E

5G is Coming

Industry analysts and investors believe the trajectory reverses course in 2020 (Exhibit 6, 7). Gartner sees total device sales returning to 1.5% growth, with the premium smartphone segment leading the way with 5.4% growth. Apple, whose FY19 sales are expected to be off 2.5%, is projected to grow 4.6% next year (Exhibit 8). Estimates for other smartphone linked stocks, like Samsung, Qualcomm, TSM, Skyworks, and many others, reflect similar optimism (Exhibit 9). The reason seems to be 5G.

Carriers in South Korea, UK, Germany, US have launched 5G “commercial service” but the network availability is largely limited to specific congestion hot spots and fixed residential trials (Exhibit 10). More is expected for 2020, with countries like China and Japan expected to enter the fray. Gartner projects that more than 10% of all mobile phones sold in 2020, nearly a third of all premium smartphones, will be 5G-capable. Given the limited network availability, the modest initial benefits available to users, the narrow range of available models (a 5G iPhone will not appear until this time next year), the relative price of 5G devices and service, and the historical record of new wireless technology adoption, we believe this scenario is extremely optimistic. Indeed, the likelihood of tepid performance reviews for the initial 5G devices and the potential for a broader introduction of 5G models for 2021 suggest that the immediate impact may be further dithering on upgrade decisions rather than a firm resurgence of demand. Instead, we suspect that many early

Exh 6: Analysts expect 2020 total mobile phone unit sales to rebound

Exh 7: Analysts expect 2020 mobile phone revenue to rebound, despite price drops

Exh 8: Consensus Sales and Growth expectations for Apple in FY20 are optimistic

Exh 9: Similarly, consensus estimates for smartphone related stocks are optimistic

5G adopters will largely come from users that already upgrade their smartphones on an annual basis making the effect on premium device sales very unlikely to dramatically turn the tide.

More intriguing is the rumor that Apple could introduce a sub-$400 iPhone model in the spring. This may or may not be true and would certainly be a major strategic departure for a company that has fiercely

Exh 10: Summary of 5G service launches and suggested timelines in key markets

Exh 11: Overview of iPhone model launch price ranges and ASP over last 5 years

defended its bone fides as a luxury brand (Exhibit 11). However, the impact could be substantial. First, Apple’s cheapest phone, the iPhone XR, now sells for $599, down $150 from its intro a year ago. At the previous price point, $749, the model was believed to account for nearly half of iPhone sales in the US and is responsible for a 3-5% decline in the ASP thus far in FY19. The rumored new model, which would feature the same processor as the newest flagship models, would be priced a full third lower. Arguable, this product could cannibalize a significant share of demand for higher priced models, sharply hitting ASPs and revenues even as it boosts unit volumes. Second, a new, dramatically cheaper iPhone in the spring could dull some of the luster for the expected 5G launch in the fall, pulling upgrades forward but sapping momentum for the more expensive launches. Because of these likely effects, we are skeptical that management would take this tack after years of emphatically denying it.

Still, a special low-priced model focused just for emerging markets could be the ticket to drive used phone buyers into the stores for a new model, thus juicing overall volumes without putting sales of the more expensive products in developed markets at risk. Still, the backlash from loyal users in the US and Europe frustrated at the unavailability of the low-price model could be considerable. We will watch these developments closely.

A Digression: Which Came First, The Smartphone or the Services?

In the midst of this great smartphone malaise, Apple pivoted away from its narrative of never-ending iPhone demand to one where its future growth would come from the services that it would provide to its hundreds of millions of loyal users. Of course, huge lucrative services franchises from Google Search, to Facebook’s Social Networking and Amazon’s Shopping had already been well established on iPhones, Androids and every other possible online platform, but for Apple, it was relatively new vector.

Steve Jobs was a disciple of the device. First the Mac and then the iPhone, a piece of beautiful hardware, tightly integrated to an intuitive software environment was the beating heart of the Apple ecosystem. Services were in service to that central device, ideally proprietary to Apple, and if not, closely controlled by the company to remain in harmony with the user experience on the device. This was an enormous advantage in the early years of the iPhone, as alternatives (mainly Google’s Android), pulling together 3rd party software and services, failed to offer the convenience and performance of Apple’s tightly orchestrated solution. Apple was content to operate its App Store and charge 30% to independent developers wishing to connect with iPhone users and to negotiate lucrative terms for a handful of apps deemed important enough to install as defaults. As certain functions would gain popularity or importance, Apple would often develop their own version as a default and look to crowd out the 3rd party version. These apps – Apple Maps, iCloud, Apple Music, and others – were often reviewed unfavorably vs. the services that they were meant to replace, but by delivering them pre-loaded they gained user engagement nonetheless.

The services that Apple developed would not be made available on any other platform – their purpose was to enhance the value of the device, not to generate revenue on their own, per se. Apple’s chief iPhone rival, Google, saw things exactly in reverse. The Android operating system was developed and licensed to all comers for free, explicitly intended to serve as an access vehicle for Google’s Search, Maps, YouTube, Gmail and other services franchises. A user might love their smartphone, but their primary relationship would be with those services in the cloud and the experience would be consistent no matter what device was used to connect to them. The Google philosophy – they now term it “ambient computing” – has other adherents. Amazon wants to establish something similar with its cloud franchises and its Alexa digital assistant. In China, Tencent fronts smartphone operating systems with its comprehensive WeChat App, which bundles a panoply of services into a single platform portable from device to device.

In this context, Apple’s new focus on growing services revenue is late to the party. The most recent quarter saw services revenues of $10.9B, for a run rate of over $40B with YoY growth of 19% (Exhibit 12). While management touts its progress in media – Apple Music, Apple News and Apple TV Plus – a third of those services revenues are the 30% fees that it charges independent developers in its App Store. Apple Care – maintenance contracts for Apple hardware sales that cost as much as 20% of the purchase price – are also a substantial piece of the services revenues (and sales growth, as recent quarters have included revenues from a popular one-time program to replace iPhone batteries). Apple Pay, a truly innovative service with substantial long-term opportunities associated with it, is still a small slice of the pie given the 15bp fee earned on transactions. Apple’s other branded services – the aforementioned media services, iCloud storage, and others – have traction largely due to free trials bundled with new device purchases that convert to paid subscriptions with inaction by the user. Again, services in support to a device business. Other than Apple

Exh 12: Historical quarterly Apple Services revenue and YoY growth, 1Q12 – 3Q19

TV – which demands a connection to the living room screen where Apple has been less successful – these services are exclusive to iOS and Mac devices.

Replacement is Down but Engagement is Up

The installed base of mobile phones is static, and the replacement rate is trending down, but those users are racking up more screen time. E-Marketer estimates that US adults are spending 3 hours and 43 minutes per day engaged with mobile devices, up 8 minutes YoY and for the first time, exceeding the time spent watching TV (Exhibit 13, 14). Of that time, nearly 3 hours is spent on smartphones, up 9% YoY. Riding this trend, digital ad spending is forecast to be up 17.6% this year to over $330B worldwide, more than half of all measured media advertising spending for the first time. US e-commerce spending is expected to be up 14% this year to nearly $600B.

In this context, mobile services are vigorous growth market. We break it into four basic categories:

  1. Content – Things to read, images to see, sounds to hear, video to watch, games to play, social interactions to conduct. Content is the biggest element of mobile user engagement and is monetized via ads, subscriptions and fees. Huge franchises like Facebook’s social networks, Netflix, Spotify, Google’s YouTube, Twitter, Snap, and others fall into this category, generating hundreds of billions

Exh 13: ‘Digital’ accounts for over half of the daily avg time spent consuming Media

Exh 14: Avg. Time Spent on Mobile Phones in the US passing TV, 2014 – 2021E

of dollars in revenue, mostly via mobile engagement. This is where Apple is making its biggest bets on services – Apple Music, Apple News, Apple TV Plus, and Apple Arcade are all content subscription services largely exclusive to iPhone users and targeted at their loyalty and inertia vs. well established alternatives in each category (Exhibit 15).

  1. Commerce – Shopping and buying. Obviously, Amazon is here, along with services like Booking Holding’s Priceline, GrubHub, eBay,, and others. The App Store and Google Play are commerce services, arguably, monopolizing the distribution of apps on their respective platforms.
  2. Tools – Services that help you to accomplish things. Maps, photo processing, cloud storage, payments facilities (PayPal, Apple Pay, Google Pay, etc.), messaging, calendars, and other utilities are all tools. So are AI assistants like Alexa, Siri or the prosaically named Google Assistant. Monetization may be via ads or fees, or the service might be a freebie, offered to increase the user’s loyalty to a platform. There has been a lot of innovation in tools in the past few years.
  3. Gateways – Gateways are mobile apps that provide access to services that are largely delivered outside of the digital domain, but increasingly integrated to a mobile experience. Uber is an example, tying personal transportation to a digital platform. We believe that there are considerable opportunities for gateway services to disrupt major economic sectors, such as transportation (ride hailing leading to autonomous services), healthcare (wellness tools and telemedicine tied to the administration of health plans), and financial services (mobile payments leading to deposits, loans, investing, and other consumer services). Gateways demand orchestration of many elements of a service, often provided by many players in a broader ecosystem, and the apps will be complex and sophisticated. We believe that the top platform players – Apple, Google, and Amazon – all see opportunities in this arena as their next big thing.

Exh 15: Mobile services can be classified into 4 broad categories

Here Comes the Government

The political winds are blowing against mobile services, many of which lever information about usage and location to target content and suggest purchases to consumers. The EU has been aggressive on privacy, demanding disclosure and consent for capturing user data, and on anti-trust, issuing multi-billion Euro fines and insisting upon competitive remedies for Google while charging into investigations of Facebook, Amazon, Apple and other major players in the mobile ecosystem. The US may be right behind, with top candidates for the Democratic Presidential nominations openly calling for tech industry break-ups with only token opposition from Republicans, who seem to obsess over possible ideological bias in the information recommended to consumers. Despite the rhetoric, we believe that politicians on both sides of the Atlantic will find it difficult to really stem the power of the top mobile franchises without badly damaging the quality of service they provide to consumers and without gifting other large tech platforms with open opportunities to fill the gaps. You would have to break them all up … or none of them.

Exh 16: Apple’s App Store has come under attack from multiple popular services

Even though we are skeptical that regulation will really destroy the growth potential of the top companies, there are some concerns. One key issue has been largely ignored. In May, the Supreme Court rejected Apple’s plea to have an anti-trust lawsuit brought by developers against its restrictive App Store policies dismissed. Apple has long asserted that its refusal to allow distribution of iOS apps outside of its store protects its users from malware and poorly designed products, and that the work it performs in vetting each app justifies its 30% take on the revenues everything distributed through its store. The developers see it differently, demanding competitive alternatives to the Apple App Store, a more transparent and fair

Exh 17: Summary of threats to Apple’s Walled Garden approach

approval process, and freedom to integrate their apps with broader digital strategies without triggering revenue sharing with Apple. While this will likely take a year or two to play out, it is more than plausible that the courts will side with the developers and that the app monopoly that fuels a third of Apple’s services revenue could be badly compromised (Exhibit 16, 17). We note that this would also likely hurt Google – while it does allow alternative app distribution, in practice, the Google Play store extracts similar rents.

Beyond the Smartphone

As the mobile phone installed base plateaued and as the sale of new smartphones waned, a range of new connected devices has emerged. For Apple, these products are peripherals, meant to augment the functionality of an iPhone which remains the dominant element of a user’s digital experience (Exhibit 18, 19). For Google, Amazon and other vendors, the devices are alternative access points to their cloud-based service franchises. Still, despite the differing philosophies behind them, peripherals or alternative access devices are a hot market.

Apple’s meticulous design and integrated view on new additions to its private ecosystem allowed its Apple Watch to succeed where many others failed. Both a buzz-worthy accessory and a meaningful extension of iPhone functionality, the watch has grown to a $5B+ business in just over 4 years of availability, still growing at a nearly 50% YoY rate. The success of the Apple Watch has pulled along “me too” products from Samsung and others, along with the connected watch OG Fitbit, but the Apple product still holds about 46% of the global market in the category. Google and Amazon, aggressive players in other categories of connected devices, have been curiously absent. For Apple, the sensor laden Watch is its lead product in what we expect to be a major push into health-related services in the coming years. Estimates suggest that the installed base of Apple Watches is likely between 60 and 70 million users, less than 10% of the roughly 900 million iPhone users, so there is likely considerably more headroom for growth.

Exh 18: Global market share for smart watch sellers, 2017 – 2019E

Exh 19: Global Smartwatch Unit Shipments Forecast, 2017 – 2023E

Exh 20: Global Smart speaker Installed Base Forecast, 2017 – 2023E

A year and a half after delivering the Watch, Apple debuted another pioneering peripheral, taking the ubiquitous earbuds that had emerged from the iPod era and rethinking them from the ground up. Small, wireless, and able to interact with the pocketed iPhone with its Siri AI assistant, Airpods were an instant hit, catching the Android economy completely unaware. A year later, poorly designed copycats from Google, Samsung and several others hit the market, but it was not until this year that decent alternatives for users outside the Apple envelope came to market. We see enormous potential for products at an affordable price point that can enable handsfree interactions via spoken commands or gestures. Here, Apple’s muddling along with Siri opens a door for Amazon and Google and their superior assistants. Both companies have recently announced new AI connected earbuds and expect the products to encourage new modes of interaction with Alexa and Assistant. Three years in, the installed base of Airpods is somewhere between 50 and 70 million and sales are growing even faster than the Watch. We also believe that with the potential for lower price points and new use cases, the potential penetration is likely to be significantly higher than for the Watch. The same is true on the Android side, where the installed base of devices is three times the size of the iPhone.

Amazon was the pioneer for that other popular holiday gift, the smart speaker. The first Echo hit the market at the end of 2014 and was a surprise hit, catching would-be rivals flatfooted. Featuring the AI assistant Alexa, the Echo parlayed a simple set of initial use cases – media playback, simple information requests, and home control commands – into growing set of skills supported by a broad range of service partners. Google followed with its “Home” devices a full two years later but gained traction by virtue of the superiority of its Assistant and the Search franchise behind it. Both companies were content to sell the devices with little profit to proliferate endpoints able to access their lucrative services franchises – shopping for Amazon and Search/YouTube for Google. Independent device makers, without the service tie-in, found it hard to compete at those prices, typically opting to add the AI assistant capability via license with Amazon, Google or both, while differentiating on the performance of the device itself – e.g. Sonos speakers. Meanwhile, Apple was a bit flummoxed – a device that didn’t further the hegemony of its smartphone flagship didn’t fit well strategically, and the resulting entry, high priced and under functioned, was a flop. We believe that the assistant functionality, accessed in many modalities (e.g. spoken commands, gestures, or simply context) will be ubiquitous going forward (Exhibit 20, 21).

The last category of connected devices is a bit of a band-aid. Almost every household has multiple televisions, replacing them infrequently. Until a few years ago, those TVs were connected directly to a proprietary box, rented from a Pay TV provider and operated via a proprietary remote control, that fed channelized content to the screen. If there was a second input, a DVD player, VCR or DVR, it took a secondary connection and required the user to find an alternative remote to operate it. A host of alternative options have since emerged, breaking the cable domination of the default input port to enable easy access to streaming video and other non-PayTV media. Apple was in this game fairly early, but without obvious synergies to the iPhone ecosystem, its products were undistinguished. Gaming consoles and other boxes gained the ability to control streaming media, as did those rental boxes from the cable company, and new TVs offered their own interfaces to manage the circus of inputs. Cheap dongles from Google and Amazon allowed users to easily stream content directly from WiFi onto the TV. Still, the holy grail of a single interface that allows a household to browse or search content across multiple services and easily select amongst them has not been delivered, as content providers resist ceding control of their direct relationship with their users. Despite new enthusiasm for Roku and a push from Apple and others to aggregate streaming services to a single interface, we do not expect the jumble to improve much in the near term.

Exh 21: Key elements of success for smart assistance – which is crucial to the “ambient computing” model of Google, Amazon and rest

Winners and Losers

The sluggishness of the smartphone market and the excitement in services and peripheral devices has implications for investors. To start, we are concerned for the value chain of companies involved in the manufacture and sale of mobile phones – consensus expectations reflect market growth that we do not believe will materialize in 2020. This starts with Apple, which does have nice growth potential from its services and even more so, from its peripherals businesses but still sinks or swims on the sales and profitability of its flagship iPhone franchise. A disappointment on that side will be hard to cover with extra Airpod sales. Other smartphone focused companies include Samsung (NAND Flash will also be affected by smartphone disappointment), Xiaomi, chip suppliers (e.g. Qualcomm, Taiwan Semi, MediaTek, Qorvo, Skyworks, etc.), Corning, and others. We do believe that a 2020 disappointment could be followed by a significant 2021 surprise as a 5G-driven upgrade cycle begins 12-18 months behind consensus expectations.

The winners are those that can exploit the massive installed base of users and their growing engagement to monetize via advertising, commerce, subscriptions or fees. Here, we see the mobile market as healthy for platform companies like Alphabet and Amazon and for well positioned mobile friendly services, like Facebook, Netflix, Spotify, Twitter, Pinterest, and others. We note that some mobile app companies will face competitive pressures – for example, Uber and Lyft – so a strong environment is not a panacea.

Exh 22: Summary of near-term Winners and Losers in the Smartphone ecosystem


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