Smartphones Today: Looking High and Low

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SEE LAST PAGE OF THIS REPORT Paul Sagawa / Artur Pylak


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October 1, 2013

Smartphones Today: Looking High and Low

  • All of the major smartphone players face big questions in 4Q. Media types gushed over the new iPhones and existing customers stood in line to buy them in record numbers, but by resolutely ignoring the global consumer’s preference for larger screens and lower prices, has AAPL just traded another swath of market share for six more months of superior margins? On the Android side, leadership in smartphone specs has zoomed Samsung to leading share and enviable margins, but have high-end competitors like LG and Sony leapfrogged Samsung’s flagships and can shockingly low-priced, “good enough” products from emerging markets rivals, like Xiaomi, Lenovo, ZTE, Huawei, Spice, Karbonn, and Micromax, dominate the fast growing emerging markets and bite into Samsung’s profits? Google is taking a different tack with the design forward Moto X, which emphasizes personalization, a smart interface, and long battery life – does it have a chance to be a game changer? Microsoft is taking its only real OEM in house, but with NOK’s non-Windows products poised for a free fall and the Lumia line making only slow progress, can this deal possibly workout longer term? Finally, QCOM’s been on a big winning streak with its newest SOCs, but its bread-and-butter high-end products face a decelerating market, while Asian upstarts MediaTek and Spreadstrum are already dominant in the fast growing low end – can QCOM sustain its earnings growth against those trends? We believe that the answer to all of these questions is yes.
  • New iPhones driving upgrades not share gains. 9M launch weekend iPhones are a great start, but note that 1-2M units were 5C channel fill and that the 5M iPhone5 compare did not include the 2M unit Chinese launch a few weeks later. Still, with as many as 40M loyal iPhone users eligible for upgrade before year end, strong sales for the coming quarter appear well in hand. Nonetheless, 2014 will bring a fresh crop of Android “must-haves”, exacerbating the seasonality that has plagued AAPL the past two years. High-end smartphone sales are decelerating and the iPhone’s share has plateaued. Given an unequivocal denial of interest in the hot low-end market, at least a year’s delay with increasingly popular large screen models, and glacial progress on revenue-generating cloud-based services, it’s hard to make a case for a sustainable reacceleration in sales growth. That said, the high-priced new models do support near term stability in margins, although increasing competitive pressures and an ongoing mix shift toward lower profit products will be a continuing drag.
  • High end Android rivalry heating up. Samsung has led the spec wars, but new smartphones from LG and Sony have leapfrogged the Galaxy S4, with better processors, screens and cameras. Meanwhile, GOOG’s Moto X eschews this one-upmanship with pedestrian “specs” but well-praised ergonomics, battery life, personalization and proprietary software features. With another round of new models due for 1Q14, price pressures appear on tap, with platform provider GOOG, increasingly dominant SoC vendor QCOM, and HW licensor ARMH the only obvious beneficiaries.
  • Red hot low-end smartphone makers all chose Android. Total smartphone unit growth of nearly 50% has been partly offset by a 9% YoY drop in ASP, as demand for sub-$250 devices in China, India and other developing markets explodes. This dynamic has shifted global market share from 1st-world leaders, like Apple, Samsung and HTC, toward emerging market rivals, like Lenovo, ZTE, Huawei, Xiaomi, MicroMax and Karbonn. ABI projects the low-end segment to rise from 29% of the global market today, to more than 46% in 2018, fuel for continued growth of these brands, which can be expected to flex their increasing clout by moving further upscale to challenge today’s market leaders in developed markets as well. This will add to the price pressures already starting to play on AAPL, Samsung, and others, while favoring GOOG’s Android ambitions.
  • MSFT forced to buy NOK while waiting for enterprise to go mobile. MSFT knows that mobile devices will eventually take over its bread-and-butter enterprise market, and it wants to be prepared. So, when NOK, Windows Phone’s only champion, threatened to go Android, management was forced to act. In the end, we expect MSFT’s phone-to-server Windows 8 strategy to pay off, but keeping the smartphone platform viable in the near term will be very expensive. Ultimately, we expect the clunker RT platform to merge into Windows Phone, leaving MSFT with 2 related platforms bridging from smartphones to cloud-based VMs, and for enterprise adoption of Windows 8 to improve its reception in the consumer market.
  • QCOM can more than hold its own vs. MediaTek and SPRD. We believe QCOM is consolidating its leadership in mobile silicon, positioning itself to deliver sustained growth and profitability. In the high-end, market share gains on superior new SoC offerings, tablet design wins, and adding RF to the addressable market should more than offset deceleration in the end market. At the low-end, QCOM’s scale and design integration excellence have it profitably winning business from its Asian rivals. Moreover, market concerns about LTE royalty rates are misplaced.
  • BBRY circling the drain. Fairfax has made a bid, but without secure financing, investors may not be safe yet. Horrific 2QFY14 results reflect the death throes of the smartphone business, while the flash flood of messaging apps, particularly in the growth markets in Asia, Latin America and Africa, is killing the once valuable Blackberry Messenger franchise. BBRY’s patents have been widely cross-licensed to device OEMs, negating their value in the smartphone IPR wars – note the lack of royalty revenue and litigation success. Even the cash holdings are suspect – trapped overseas and burning at an accelerated pace. The long slow death of BBRY has been good to GOOG and AAPL, but the biggest beneficiary may prove to be MSFT, once the enterprise market finally goes mobile.
  • We favor components and software over devices. AAPL may ride its replacement cycle to strong Holiday sales, but product cyclicality, high-end smartphone deceleration, and new price competition loom in 2014 against buoyant expectations. Samsung, HTC, LG and Sony will be in an increasingly ugly scrum for global market share with signs that pushing processor and display specs may have hit the point of diminishing returns. The upstart Asians should have their first developed world successes in 2014, while they continue to build their dominance in China and India. MSFT will show modest incremental share gain with Windows Phone while it bleeds from the necessary death of NOK’s still sizeable feature phone franchise. The big winners are GOOG, QCOM, ARMH and a range of other component makers.

You Take the High Road, and I’ll Take the Low Road

Total global smartphone unit sales are still ripping along at a healthy 45%+ pace, but many investors see the glass as half empty. High-end device demand is decelerating – a logical consequence of the soaring penetration in developed economies and the relative poverty of consumers everywhere else. Meanwhile, competition in the segment is fierce, with major new products from most of the biggest players.

The biggest buzz is around AAPL’s two-headed iPhone launch. On further review, the 9M opening weekend is a bit less impressive than it first seemed, but with as many as 40M iPhone users subsidy eligible through the holiday season and a bump to guidance for September, the near term looks pretty bright. The problem is 2014, when these iPhones are long in the tooth and a new crop of flagship Android phones hits the shelves. iPhone seasonality has been growing more pronounced, and the fall back this year may be even more so, given Apple’s stubborn refusal to address the growing user preference for larger screen sizes or to offer any product for the non-affluent consumer. The good news? Sticking to AAPL’s traditional iPhone price points will help to sustain the epic gross margins, although the ongoing internal mix shift toward lower margin iPads remains a drag.

While AAPL guards its margins, the Android crowd may feel more heat. New flagship models with amped up specs are rolling twice a year, with models from LG, Sony and Samsung with big beautiful screens and superfast QCOM quad-core processors due in stores in coming weeks, and another round expected at the end of 1Q14. The scary thing is the sameness of the products, which largely attempt to differentiate on software tweaks, casing materials and camera sensors. GOOG’s own Motorola is zigging while the rest of the field zags, with the pedestrian specs of its Moto X offset by ergonomics, battery life, and personalization. Meanwhile, 5 of the top 6 smartphone brands in China are now homegrown – with Lenovo, Yulong, ZTE, Huawei and Xiaomi all gaining on market leader Samsung. Indian manufacturers Micromax and Karbonn are now numbers 2 and 3 at home, with Samsung’s lead shaved to just 400bp. The challengers are selling well made devices with specs 2-3 years behind top of the line, at prices less than half those of the top foreign flagship models. The success of these products likely presages a move upscale and into developed markets.

We suspect MSFT agreed to buy NOK’s phone business under threat of insurrection. As enterprise buyers slowly organize around standards for mobile, Windows Phone will be a key piece of MSFT’s long-term platform strategy. With NOK selling 80% of the devices using the platform now and dancing around alternative OS options, MSFT could not afford to call the bluff. The transition will be tough and expensive, as the non-Windows products are wound down, but we see having a consistent platform from smartphone to server as a critical asset for MSFT in the future of enterprise IT. As a side note, we doubt that the enterprise IT future will have BBRY in it, and expect MSFT to be the prime beneficiary as the once ubiquitous email platform circles the drain.

We continue to favor components over smartphones, including QCOM which we believe will take share in both smartphones and tablets while expanding its addressable market to RF. MediaTek and SPRD will enjoy the explosive growth of low end smartphones, but so will QCOM. GOOG and ARMH will also benefit from the global domination of Android. MSFT will certainly suffer for mobile in the near term, but has the potential to dominate the future of enterprise software.

Smartphones for the People

Gartner suggests that 2Q13 global smartphone demand was up nearly 50% YoY on a unit basis, and, even factoring in a 9% ASP decline, up nearly 40% on a value basis (Exhibit 1). Published forecasts from IDC and Strategy Analytics suggest a very similar perspective (Exhibit 2). So then, why are investors so worried?

Exh 1: Worldwide Smartphone Sales by Vendor, 2Q12-2Q13

Exh 2: Quarterly Global Smartphone Shipments, 1Q11 – 2Q13

Parsing things a bit more granularly, smartphone growth by vendors that participate primarily in the high end smartphone market – e.g. Apple, HTC, Blackberry, Sony – have been losing global share, while vendors with a low end smartphone focus – e.g. Lenovo, Yulong, ZTE, Huawei, Xiaomi, CoolPad, Micromax, Karbonn, and Spice – have all posted well above average growth, challenging full line smartphone king Samsung for the market lead in both China and India. This speaks to the red hot demand for smartphones at sub-$300 price points, devices that feature specs only 2-3 years behind the flagship high-end models and that almost exclusively run Android. It also speaks to the specter of market saturation looming ahead for brands dependent on the developed world. 64% of American wireless subscribers wield smartphones (Exhibit 3). The 5 biggest EU economies all had better than 50% smartphone penetration as of the beginning of the year. South Korea and Singapore lead Asian penetration with more than 70% of wireless subscribers carrying a smartphone.

Exh 3: Smartphone Penetration by Market, 2Q13

While most forecasters see room for smartphone penetration to go much higher, even in mobile mad countries like South Korea, the incremental consumer in those markets is likely to be less affluent than the existing users, and thus, more likely to be looking downscale for their first smartphone. Certainly there are a lot of aspirational purchasers in emerging markets as well, who have been stepping up to buy their Galaxy S4s and iPhones, but it’s a convincing argument to suggest that most of the Chinese consumers that can afford a $700 smartphone already have one. Still, based on the sales of iPhones, Galaxies, and the like, high-end YoY market growth has almost certainly dipped below 20%, and likely for good, with the very large part of demand coming from replacement rather than new blood (Exhibit 4).

With this, the high-end smartphone market is slowly becoming a bit of a zero sum market share game for device makers, subject also to the ebb and flow of subsidy-driven global replacement rates. In response, the leading brands are experimenting with wearable adjuncts, like “smart-watches” to extend the utility of their products and to carve a bit more cash out of their customers’ wallets. The jury is still out as to whether this will prove to be more than a minor niche accessory for fitness enthusiasts. Others, notably Google and Amazon, aim to monetize their smartphone platforms through well-integrated cloud services carrying subscription fees, advertising, merchandising services and e-commerce. This tack appears far more promising.

Exh 4: Global Smartphone Shipments by ASP range

An Apple (or Two) a Day

Apple has played its hand like the master marketer that it is. When iPhone honcho Scott Forstall abruptly exited the company in April, the reins were handed to legendary design guru Jony Ive, who immediately embarked on a massive iOS make over. While the scope of aesthetic changes – translucent icons, shimmering effects, and a repudiation of skeumorphism – greatly outweighed the functional improvements – better multi-tasking, and more direct access to important functions – the fanfare when the update was revealed at June’s Worldwide Developers Conference was epic. This set the stage for the new models to be introduced in concert with the fall iOS7 release.

After a summer of rumors had analysts and pundits anticipating a low-cost iPhone, that would position Apple to play for the fastest growing geographic and demographic segments, the company introduced the high-priced iPhone 5S, along with the slightly lower priced, but still firmly high end, iPhone 5C. The 5S adds a fingerprint scanner for security, a souped-up processor, and slick camera enhancements, improvements that that ticked the boxes for spec obsessed bloggers. However, the typical iPhone user is likely more excited by the new gold color option for the 5S, than by the subtle changes in functionality – few apps can really make use of 64bit processing, and more than half of iPhone users have not password locked their phones. The 5C is an iPhone 5 in a bright plastic case with a $550 price tag. Still, with as many as 40m iPhone users reputedly rolling off of contract before year end, there is a lot of pent up replacement demand to serve (Exhibit 5).

Ahead of the iPhone opening weekend, Apple pushed analysts to more conservative forecasts like a magician forcing the Queen of Hearts. Rumors of parts shortages for the flagship 5S spread, and the tech press set market expectations for a muted 6M units, only modestly topping the 5M units sold a year ago during the iPhone 5 debut. Friday saw the lines of rabid fan-boys and gray market resellers, and while the newly iconic gold model sold out quickly, white or black 5S models were still available for most of the weekend, while the 5C was well stocked on shelves everywhere. On Monday, Apple triumphantly announced 9M units sold, an 80% bump up from the previous first weekend record, and raised their guidance for the quarter ending in September, giving journalists their story lead, and leaving analysts with a bit of egg on their faces.

Exh 5: Estimated iPhones Eligible for Upgrade, 2Q09-3Q13

Ex post, Monday afternoon’s brokerage reports noted that the shortages of the 5s had not been as acute as they had been led to expect and that the 9M units likely included as many as 2M iPhone 5Cs that were still sitting on store shelves as inventory fill. Furthermore, this year’s iPhone launch weekend included China and Japan, while last year’s 5M unit iPhone5 launch, used as a yardstick, had not. The iPhone5 went on to sell nearly 2M units in its Chinese launch a few weeks later. The year ago compare also did not include sales of the price-reduced 4S, which would have been analogous to the cosmetically revamped 5C (Exhibit 6). In this context, Apple’s big weekend was considerably less impressive, but the stories had already been written.

So where does all of this leave Apple? It is in the same place where it has been – squarely focused on a high-end smartphone market that is decelerating. Within the high-end market, iPhone loyalists will dutifully upgrade, although some may opt for the less expensive 5C vs. the flagship 5S. Apple could win some new customers with the youthful appeal of the colorful 5C, but its stubborn refusal to deliver models with a larger than 4 inch display puts it on the wrong side of consumer smartphone purchase trends. The new product hype and the large cohort of upgrade ready loyalists should offer a tailwind through year end, while the stalwart pricing strategy and clever 5C cost consciousness could yield a break in the recent margin slide.

Exh 6: First Weekend iPhone Sales History

However, 2014 will bring the January doldrums followed by a raft of new Android flagship devices to cast the then 6-month old iPhones in a less flattering light. Apple’s one year product refresh cycle has been good for margins, but has yielded an increasingly pronounced seasonality in recent years under relentless pressure from competitors on a more aggressive development schedule (Exhibit 7). With the high-end market deceleration and the subtle improvements to Apple’s product line, the impact could be more jarring this time. In this context, consensus expectations for reaccelerating sales growth and margin improvement throughout FY14 seem considerably overaggressive.

Exh 7: Quarterly iPhone Sales, Launch to June 2013

It’s Lonely at the Top … NOT

On the Android side, Samsung has been king of the hill for a few years, winning the “spec” war to earn global smartphone market share dominance and profit margins second only to Apple. However, the advantage gained from Samsung’s components strength may be eroding, as the benefit to users of higher resolution displays and faster processors moves far past the point of diminishing returns. This fall, resurgent rivals LG and Sony have launched new models with specs that compare favorably against Samsung’s aging flagship Galaxy S4 and its newly launched Note 3 phablet. Google’s own Motorola unit decided to zig rather than zag, and brought out the Moto X, which steps back on display resolution and processor cores, to focus on ergonomics, battery life, and personalization (Exhibit 8-9). Google’s separate Nexus program, which co-develops Google branded devices with licensee partners, is expected to deliver a new LG-built model featuring top-of-the-line specs at a relative bargain price point.

Exh 8: Profiles of Flagship Smartphone Offerings, 1H 2013

That’s just 2013. Starting with the Consumer Electronics Show in early January, another round of flagship Android device announcements will begin, with the new smartphones likely to hit the stores in early spring. HTC will have a follow on to its critically well-received HTC One. Motorola is believed to be working on a lower priced version of the Moto X to bring personalization to the masses. Samsung will unveil its Galaxy S5, and, rumor has it, perhaps a higher price point luxury model that could introduce flexible display technology for the first time.

Importantly, there will also be new models from ambitious Chinese manufacturers looking to expand out of their home market with well-spec’d and well-priced models intended for the developed world. Huawei broke the iceberg a year ago with its ultrathin Ascend Android smartphones – it will be back with friends in the coming year. Lenovo and ZTE are obvious candidates to make the leap to the west, with fast rising new brands like Xiaomi, CoolPad, or India’s MicroMax also likely eying the export market (Exhibit 10-11).

Exh 9: Profiles of Flagship Smartphone Offerings, 2H 2013

Exh 10: Emerging Handset Maker Devices, Q3 2013

As we wrote in “The PC-ification of the Smartphone” (
), all of this competitive activity is almost certain to weigh on prices, particularly if carriers like T-Mobile are successful in promulgating a model with lower, or even non-existent, handset subsidies. As the established brands beat each other up for market share in the decelerating high-end market, with the looming specter of new competition from China and India, it will be interesting to see which one blinks first on pricing.

Exh 11: Lower-End Emerging Market Devices, Q3 2013

The Next Billion Smartphones

Back to the emerging markets, more than half of the mobile handsets sold worldwide in 2012 were NOT smartphones, and most of those were still GSM-only (Exhibit 12). This is changing quickly, as turnkey silicon reference designs have made the sub-$100 3G Android smartphone a reality, and enabled sub-$250 smartphones with performance specs rivaling flagship products from just 2-3 years ago. Demand for product at these price points is prodigious, fueling the 50% unit growth of the overall smartphone market and drawing down the global average selling price by nearly 10% YoY. By 2018, ABI projects that sub $250 devices will make up more than 46% of smartphone sales, up from 29% today, translating into annual unit volumes that could top 1B (Exhibit 13).

Increasingly, this business is the province of local brands – Samsung may still lead the smartphone market in China, but the next 5 competitors are Chinese and it seems nearly certain that Lenovo will win the top slot before the end of 2014. Likewise in India, where home grown MicroMax is just 400bp behind Samsung and growing with a bullet. Given the success and ambition of these emerging market champions, it would be a big mistake for Samsung, HTC, LG, Sony, or Google to assume that they cannot threaten them in the more established markets of the developed world. A decade ago, Samsung and HTC were just bit players in mobile handsets, the iPhone was just an idea in Apple’s labs and Google was just a search engine. Five years ago, Nokia was still, by far, the world’s biggest mobile device brand, and Research in Motion had the dominant smartphone operating system in the US. Things change quickly in the mobile world.

Exh 12: Global Phone Production by Technology, 2011-2017

Exh 13: Global Smartphone Shipments by ASP range

An Offer You Can’t Refuse

A month ago, Microsoft rattled the mobile world with its announcement that it would buy the mobile device business from its Windows Phone partner Nokia. The deal has been roundly ridiculed by tech journalists and industry analysts alike, and the cost of winding down the company’s substantial feature phone franchise will be a significant drag on earnings for as long as it takes. Still, looking past the near term pain, the deal makes long-term sense for Microsoft.

Industry scuttlebutt suggests that Nokia, which now is responsible for more than 80% of all Windows Phone devices sold, had broached the possibility that it might also license Android. Moreover, Nokia’s product roadmaps were not entirely copacetic with Microsoft’s own plans for the platform. Given the importance of Windows Phone to its long term plans, and the shaky ground it was treading with developers and other ecosystem partners, Microsoft could not afford to call Nokia’s bluff. Bringing Nokia’s device business inside would streamline the development process, and given the already less than enthusiastic commitment to Windows by other device partners, the risk of creating further conflict was almost moot. In this, the Microsoft/Nokia deal was eerily similar to Google’s acquisition of Motorola, where it is reputed that Motorola management threatened to pursue patent litigation against other Android licensees and adopt Windows as an alternative platform. Like Microsoft, Google also blinked first.

Exh 14: Smartphone OS Market Share in Major European Economies

With Nokia, Microsoft gets an excellent product engineering company with strong manufacturing and distribution assets, and a brand still well regarded in many important global markets. The most recent Kantar surveys of the smartphone market show a surprising resurgence for Windows Phone in Europe, almost certainly driven by a well-reviewed line-up of mid-range models from Nokia (Exhibit 14). Nokia is also the nearly undisputed champion of the camera phone, having introduced a ground breaking 41 megapixel sensor with high-end optics, and market leading image stabilization software.

Microsoft needs to accelerate this progress. Having a compatible platform that stretches from smartphone to desktop to server is a powerful asset to address the needs of enterprise customers as they grapple with accommodating mobile applications for their organizations. As Windows 8 becomes more firmly established in the enterprise, the value of Windows Phone to those organizations and to their employees will be considerably more apparent. Along the way, we suspect that the maligned Windows RT tablet platform will fade away in favor of extending the Windows Phone software into larger form factors. Played correctly, we believe that Windows Phone can be a viable third place consumer smartphone platform, a position that will enhance Microsoft’s broader dominance in the enterprise.

Exh 15: Evolution of Mobile Phones, 1996 – Present

Here I Go, Singing Low, Bye Bye Blackberry

Perhaps the only people in the mobile industry that didn’t see the hard times coming for Blackberry were the Blackberry executives themselves. Back in the day, Research in Motion, as it was then called, was riding high with its nearly $50B valuation and unafraid of upstarts like Apple. Shortly after the iPhone launch co-CEO Jim Balsillie dismissed it as a threat, noting that it “simply marks the entry of yet another competitor into the smartphone market” (Exhibit 15). Still, by 2008, RIM was out with its own touchscreen device, “The Storm”, which hit the market with a resounding thud. Since then have come waves of failed products, every one of them reactionary and embarrassingly late to market.

These days, it is more or less a given that the Blackberry hardware business is a goner – the company just posted a nearly $1B write-off to cover the loss of value of its vast unsold inventory of its latest “save the company” product, the Q10. Some analysts impute significant value to Blackberry’s patent portfolio, citing the top dollar paid for Nortel’s patents and Google’s seemingly desperate deal for Motorola. We are not so sure. Blackberry does not report significant patent royalty income, has not been active in litigating infringement against its IPR and as faced only minor claims of infringement against it by others. Given the immense pressure on Blackberry management, it would seem very unlikely that it would not have tried to monetize its patents through litigation if there were any grounds for suit, suggesting that the intellectual property portfolio, however extensive, is likely already cross-licensed with its major smartphone competition. If so, the IPR would be of little value to Google, or its ecosystem partners, under siege by Apple, Microsoft and others, as the existing licenses would negate any potential leverage.

Finally, the value of Blackberry Messenger, the company’s successful proprietary messaging platform, is draining away with every second. Blackberry resisted porting the service to either iOS or Android, believing that the popularity of BBM could save its struggling device business, but has nearly killed it in the process. In markets where BBM, and thus Blackberry devices, had been successful – e.g. Indonesia, South America, and Africa, etc. – have seen an invasion by third party messaging apps, such as Kakao, LINE, What’s App, Samsung’s ChatON, and many others, while BBM usage is waning in a red hot market (Exhibit 16). The long overdue port to Android and iOS has been a disaster, with epic struggles to get the app stable for release.

Exh 16: Major Messaging Applications by Users

A bit over a week ago, a consortium led by Canadian private equity concern Fairfax Financial announced an agreement to take BlackBerry private in a $4.7B buyout. Since that announcement, it has been raised that Fairfax has not yet secured the full financing for the deal. We hope that BlackBerry investors will not have yet another nasty surprise in their future.

All That and a Bag of Chips

In a smartphone world of high-end demand deceleration, explosive low-end growth, intensifying competition amongst established vendors, and the rise of new players from emerging economies with ambitions for the global market, it pays to be an arms dealer. The biggest name on that front is Qualcomm. The bear case against the company assumes that it will suffer from the same forces lining up against the major high-end device makers – price pressures in the decelerating high-end market, unbeatable competition from indigenous suppliers at the low end. We disagree.

Exh 17: Announced Flagship Mobile Processor Specs

First – It is clear that the high end smartphone market, where Qualcomm has been most successful, is decelerating. However, it is still growing and should not peak for a couple of years. In this market, Qualcomm is still gaining share with its SoC solutions – save for the iPhone and Samsung’s 3G products (both of which use Qualcomm’s modems), ALL of the major high end product releases this year have featured Qualcomm Snapdragon solutions, including Samsung’s LTE products (S4 and Note3). This is because Qualcomm’s proprietary Krait ARM processors are quicker to market than rival products based on the full ARM Cortex reference design, because Krait is lower power, higher performance and smaller footprint than Cortex, and because Qualcomm’s integrated modem implementation is clearly best in class. Moreover, Qualcomm’s dominance in high end smartphones is spreading into tablets, where it has not been as strong historically. Design wins with Google, Samsung, Amazon and others for high profile tablet projects are net share gains for Qualcomm in an important growth market, and portend future success, and incremental growth beyond the decelerating smartphone market (Exhibit 17).

Second – Qualcomm is beginning to deliver solutions to address a wider piece of the mobile device market. A new radio solution is revolutionary – one chip handles 40 different frequency bands, thus enabling device makers to avoid SKU proliferation to address geographic markets. We expect this solution to be popular, adding additional addressable market for QCOM, and opening opportunity to integrate RF into a single module reference design. Note that none of QCOM’s SoC rivals have analog design capability to offer a competitive RF solution, and thus, cannot transition easily to a single module RF/Modem/Processor solution. This increases QCOM’s share of the BOM and its differentiation at the SoC level (Exhibit 18). QCOM can apply the same strategy and extend its addressable market into sensors and power semiconductors. Thus, Qualcomm can counter deceleration in smartphones by expanding its share of the silicon content within each product.

Exh 18: Component Composition of a Premium Smartphone

Sixth – The low end smartphone market is entirely incremental to Qualcomm – most of it is replacing the 47% of device sales that were GSM only in 2012 (and thus unadressable by QCOM in either QCT or QTL). Here QCOM’s initial efforts have been very successful – it is a strong #2 in China. Not only is this business profitable and incremental for QCOM, but there is reason to believe that it will gain strength with time. QCOM’s overall scale and design excellence should yield cost advantage vs. MediaTek or Spreadstrum, who must pay for the very same contract fabs as QCOM (Exhibit 19-20). As China adopts LTE, that advantage will grow. While competitive price points will dictate lower margins than QCOM’s high end chips, the contribution will be robustly positive and rapidly growing.

Exh 19: Q1 2013 Smartphone SoC Processor Market Share

Exh 20: Smartphone Application Processor Vendor Positioning with Chinese OEMs, 1H 2013

Winners and Losers

In the short run, Apple, LG, and Sony, all of whom have new flagship smartphones coming to market, should be share gainers in 4Q13, although any Holiday joy is likely to be short-lived. We believe that competitive rivalry is intensifying, exacerbated by the sameness of products and the diminishing benefits of improving specs. This will get worse as emerging market players start to jump into the global mix, and it is difficult to recommend any of the device makers longer term (Exhibit 21).

Exh 21: Winners and Losers

As noted just above, we are more enthusiastic about smartphone components, and in particular, we favor Qualcomm. We also see ARM Holdings as a considerable beneficiary, see ongoing robust demand for high quality smartphone displays as a boon to companies like LG Display and AU Optronics, and are intrigued by sensor suppliers, such as OmniVision. While smartphones represent a relatively small piece of revenues for platform players Google and Microsoft, we believe that their position in devices is an important asset in supporting the future success of other, more value creating, businesses. Both are recommended. We also favor handset makers in the center of the low-end demand growth – particularly ZTE. A quick note on Microsoft – we believe that Windows Phone will gain a small stake in the high-end smartphone business that could grow with time as enterprises take more control over mobile applications, but our favorable view of the company is much more tied to its cloud computing and SaaS application businesses, than it is to the success or failure in mobile devices.


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