Ten Investible Things That We Think Will Happen in 2015

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January 14, 2015

Ten Investible Things That We Think Will Happen in 2015

2014 was a relatively quiet year in TMT, with the BABA IPO and the iPhone6 arguably the biggest events for investors. Our 2014 new year’s predictions were more on target than not, with calls for Samsung’s smartphone woes, IP litigation fizzling, deteriorating TV viewership, upside growth in digital ads, the rise of SaaS and the separation of the big 3 IaaS players from the pack all ringing true. Still, AAPL surprised us with the exceptional iPhone6, wireless residential broadband remains an unappreciated future, and S continued to execute like S. We are back with new predictions, listed below, including our top 5 stock picks for 2015: TWTR, TMUS, WDAY, QCOM and AMZN. Our 2014 picks were overwhelmed by the extraordinarily poor performance of S, and while we have certainly taken some risks with this year’s choices, none of them appear to have the potential for an S level disaster.

  • Surprising new initiatives from big players. GOOG could make big integrating plays in multiple directions – connected home, e-commerce and cross-media advertising seem likely, and a play in the spectrum auctions a possibility. Expect FB to introduce streaming video and for AMZN to get serious about an ad platform. Windows 10 will be a bigger deal than many expect for MSFT. NFLX could add PPV and live streaming, while softening its rhetoric on ads. AAPL had its big announcements in ’14, but look for it to tie them to a broad digital ID concept and an expanded HomeKit in ’15.
  • The cloud consolidates. The time seems ripe for deals. TWTR, NFLX, EBAY or any of the top private consumer cloud plays could draw serious interest – GOOG and BABA seem likely suitors, with YHOO a wildcard looking to redefine itself with BABA cash. Expect many smaller SaaS companies, both public and private, to be snapped up by enterprise IT players. Meanwhile, the big players on both the consumer and enterprise sides – GOOG, FB, AMZN, and MSFT at the fore – will get bigger.
  • Broadband reclassified as Title II, panic ensues. DC scuttlebutt suggests reclassification, but even with forbearances, the move would make it easier for the FCC to restrict broadband in the future tainting the prime investment case for cable stocks. Expect vigorous legal and legislative challenges, but the court of public opinion will run against the carriers and we believe “net neutrality” will stick.
  • TV ad revenue turns over, digital grows up. TV viewership has definitively turned down, and the quality of the audience from an ad perspective has been eroding for years. Meanwhile, advertisers show signs of comfort with digital ads as an alternative, as ad tech appears to finally be delivering on the promise of targeting and tracking. Look for disappointing pricing and volumes at the May TV Upfronts to hit media stocks and for continued strong monetization for digital media – GOOG, FB, and TWTR.
  • Slow adoption for mobile payments and wearables. The Apple Watch and Apple Pay piqued the attention of the market in 2014, but both wearable devices and mobile payments will be slower to penetrate the market than many assume. Very high Watch margins will contribute meaningfully to Apple profits, but unit volume will disappoint as a lofty price point and a questionable use case constrain demand. Apple Pay, while the best m-payments attempt yet, does not offer enough to either consumers or merchants to drive critical mass adoption and use. Expect a bit of backlash against the hype in 2H15, particularly as Apple comes up against the tough compare of the iPhone6 launch in the fall. Note that we expect the iPhone6 to drive significant upside to AAPL results through at least June.
  • New digital home concepts get big hype. Connected home devices will get the “wearables” hype treatment in 2015, with moves by GOOG and AAPL to manage entertainment, lighting, security/locks, sensors, thermostats, etc. from an Android or iOS platform. Key to this will be forging alliances with device vendors and breaking the standards logjam. Like with wearables, the likely payoff will be a few years out, but this year’s moves will make the pathway forward and the potential winners much clearer.
  • Chinese device brands bust out internationally. Domestic device makers like Xiaomi, Huawei, ZTE and Lenovo have begun to assert their control of the Chinese market, and are poised to move boldly onto the international stage. With low costs, excellent quality/design, and a willingness to compete aggressively for share, we expect these rising players to consolidate share in China and take a significant part of the international market in 2015. This will hurt volumes and prices for traditional device leaders, like Samsung, AAPL, LG and others. It could be surprisingly good news for QCOM, as these established license holders crowd out smaller incompliant Chinese manufacturers, in the wake of an expected settlement with Chinese authorities.
  • Enterprise cloud migration ahead of expectations, as security becomes a benefit. Hacks on private company data centers (Sony, Target, etc.) are changing perceived risks for CIOs, as moving to the public cloud puts the security onus on someone else with considerably more expertise and shares the potential pain with others. As the transition picks up momentum, the cost and technical advantages of the big three – AMZN, MSFT, and GOOG – will be even more apparent. This is bad for everyone else with aspirations in the IaaS game, and particularly bad for legacy IT vendors with a stake in the private enterprise data center.
  • SaaS shakeout with big winners and big losers. SaaS application start-ups are emerging at a furious pace, and many successes are in the IPO queue to join the fast growing players already public. The opportunities are huge, but not all of the players can be successful. We believe 2015 will see a separation between best of breed applications and also-rans. Of particular concern: “me too” apps and older vendors with subscale dedicated data centers that could become a growing cost disadvantage.
  • Our picks: TWTR, TMUS, WDAY, QCOM, and AMZN. Our 2014 calls were scuttled by S, which dropped 60% over the course of the year. MSFT and STX were strong – up 29% and 23% respectively – while GOOG (-4%) and QCOM (+1%) lost ground to the benchmark. For 2015, we expect TWTR to make a breakthrough on MAUs. TMUS will take surprising share, buy spectrum, and draw M&A interest. WDAY will grow faster and closer to profitability than investors expect. QCOM will settle with Chinese authorities, then benefit as law abiding licensees – e.g. Xiaomi, Lenovo, Huawei, etc. – beat back scofflaws domestically. AMZN will be a back half story as employee retention concerns force Bezos to deliver profit.

The SSR TMT Heatmap

Another Auld Lang Syne

1.       AAPL and Samsung will lose device share, Chinese vendors and MSFT will take it. Largely true with the rise of Xiaomi

2.       Little progress will occur in patent conflicts, leaving IPR law firms the only winners. Partially true, Apple-Samsung rapprochement globally, though litigation continues in existing US cases

3.       Digital ad growth will accelerate, with video/mobile/social driving upside. True given earnings from GOOGL, FB, and TWTR

4.       The on-line video diaspora will hit MSOs and networks in the bottom line. Starting to feel the effects with flat/declining subs, throttling by some MSOs.

5.       Wireless fixed broadband will be considered a viable future business. QCOM, Telstra, Ericsson tested 450 Mbps using carrier aggregation and advance MIMO in LTE-A Cat10 trials (Release 11). By end of decade.

6.       VZ and T subs will churn to S and TMUS and wireless capex will be up – big time. TMUS and S have reignited competition and VZ/T warn earnings hits. CAPEX continues at a steady pace, competition may boost hitting earnings.

7.       Slow progress of cloud-based payments will give false confidence to traditional players. Apple emerged with a payment system protecting payment nets, while Google dropped Wallet. MCX looms, but unclear where ads value

8.       Big enterprise shift to the cloud will benefit AMZN, MSFT, GOOG and few others. The big three have been signing on customers, though an aggressive price war hit revs.

9.       New enterprise SaaS applications will emerge to challenge incumbents. A flood of new IPOs

10.   Our 2014 top five picks – MSFT, QCOM, STX, S, and GOOG. MSFT up ~29%, QCOM up ~1%, STX up 23%, S down ~-60%, GOOGL down -4%

Status of 2014 Predictions:

1.       AAPL and Samsung will lose device share, Chinese vendors and MSFT will take it. Largely true with the rise of Xiaomi

2.       Little progress will occur in patent conflicts, leaving IPR law firms the only winners. Partially true, Apple-Samsung rapprochement globally, though litigation continues in existing US cases

3.       Digital ad growth will accelerate, with video/mobile/social driving upside. True given earnings from GOOGL, FB, and TWTR

4.       The on-line video diaspora will hit MSOs and networks in the bottom line. Starting to feel the effects with flat/declining subs, throttling by some MSOs.

5.       Wireless fixed broadband will be considered a viable future business. QCOM, Telstra, Ericsson tested 450 Mbps using carrier aggregation and advance MIMO in LTE-A Cat10 trials (Release 11). By end of decade.

6.       VZ and T subs will churn to S and TMUS and wireless capex will be up – big time. TMUS and S have reignited competition and VZ/T warn earnings hits. CAPEX continues at a steady pace, competition may boost hitting earnings.

7.       Slow progress of cloud-based payments will give false confidence to traditional players. Apple emerged with a payment system protecting payment nets, while Google dropped Wallet. MCX looms, but unclear where ads value

8.       Big enterprise shift to the cloud will benefit AMZN, MSFT, GOOG and few others. The big three have been signing on customers, though an aggressive price war hit revs.

9.       New enterprise SaaS applications will emerge to challenge incumbents. A flood of new IPOs

10.   Our 2014 top five picks – MSFT, QCOM, STX, S, and GOOG. MSFT up ~29%, QCOM up ~1%, STX up 23%, S down ~-60%, GOOGL down -4%

Potential 2015 predictions

1.       AAPL will start the year strong, cautious on tail end of year with a softer iPhone upgrade cycle following iPhone 6

2.       Outstanding patent conflicts will be resolved

3.       The ad world will see a decline in TV advertising with budgets reallocating in favor of digital

4.       Big acquisitions are forthcoming: FB and Yahoo likely acquirers for $1B+ properties, while GOOGL will continue to scoop up small intriguing privately held companies

5.       Amazon will start to see the fruits of investments play out, though Bezos won’t share the spoils with Wall Street

6.       The FCC will reclassify broadband as a Title II service with provisions for forbearance

7.       US Wireless wars will heat up with TMUS and S gaining subs and spectrum, T/VZ earnings will take a hit on lower margins and more CAPEX

8.       Enterprise cloud price wars will continue between web-scale players AMZN, GOOGL, and MSFT, while old line names like ORCL, IBM, HPQ, and CSCO will aim for differentiated offerings, e.g. in-country data centers

9.       More SaaS names will IPO, the space will see a shake out in favor of stronger names

10.   Our 2015 top picks – GOOGL, QCOM, TMUS, TWTR, and XXX

1.       AAPL and Samsung will lose device share, Chinese vendors and MSFT will take it. Largely true with the rise of Xiaomi

2.       Little progress will occur in patent conflicts, leaving IPR law firms the only winners. Partially true, Apple-Samsung rapprochement globally, though litigation continues in existing US cases

3.       Digital ad growth will accelerate, with video/mobile/social driving upside. True given earnings from GOOGL, FB, and TWTR

4.       The on-line video diaspora will hit MSOs and networks in the bottom line. Starting to feel the effects with flat/declining subs, throttling by some MSOs.

5.       Wireless fixed broadband will be considered a viable future business. QCOM, Telstra, Ericsson tested 450 Mbps using carrier aggregation and advance MIMO in LTE-A Cat10 trials (Release 11). By end of decade.

6.       VZ and T subs will churn to S and TMUS and wireless capex will be up – big time. TMUS and S have reignited competition and VZ/T warn earnings hits. CAPEX continues at a steady pace, competition may boost hitting earnings.

7.       Slow progress of cloud-based payments will give false confidence to traditional players. Apple emerged with a payment system protecting payment nets, while Google dropped Wallet. MCX looms, but unclear where ads value

8.       Big enterprise shift to the cloud will benefit AMZN, MSFT, GOOG and few others. The big three have been signing on customers, though an aggressive price war hit revs.

9.       New enterprise SaaS applications will emerge to challenge incumbents. A flood of new IPOs

10.   Our 2014 top five picks – MSFT, QCOM, STX, S, and GOOG. MSFT up ~29%, QCOM up ~1%, STX up 23%, S down ~-60%, GOOGL down -4%

2014 brought the 7th anniversary of the iPhone, and with it, a capitulation of sorts from AAPL, which finally acceded to the obvious reality of its users’ needs and brought out big screen models. That this was the big news of the year speaks to the maturity of the generational paradigm shift across the TMT landscape that was catalyzed, in large part, by that first iPhone. The major changes – mobile devices, cloud-based apps, streaming media, wireless networks, public cloud data centers, SaaS applications – are long underway, and most innovation is really around new expressions of those concepts and technologies to support them.

Our predictions for last year largely played out that way. We saw the rise of Chinese smartphones and called Samsung’s troubles, although we didn’t see the iPhone 6 juggernaut coming. We said IP lawsuits would go nowhere, and higher court rulings dealt stinging defeats to patent plaintiffs. Digital ad spending accelerated as we thought it would. The on-line video diaspora did begin to hit MSOs and networks, with cord cutting and falling ratings weighing on the media sector. We predicted that the enterprise shift to cloud hosting would disproportionately benefit AMZN, MSFT and GOOG – this is largely true, although a price war has driven share consolidation at the expense of profit. As expected, the SaaS application market is flooded with competition, with dozens of IPOs in 2014 and many more in queue for 2015.

We whiffed on our prediction that wireless residential broadband would be acknowledged as a future threat – the technology is still on trajectory for relevance by the end of the decade but few analysts seem to be looking that far out. We were half right in projecting big subscriber gains for TMUS and S at the expense of VZ and T – it turned out that S owned by Softbank still executed like S. We thought that the slow progress of mobile payments would yield false confidence for the traditional payments chain – instead, ApplePay, which perpetuated the credit card status quo in its initial implementation, provided that over confidence.

Our predictions this year cover some of the same ground. We expect bigger announcements out of the top web players – GOOG, AMZN, FB, and NFLX. We also expect a big year for TMT bankers, with those same players (and some desperate old paradigm companies) opening their checkbooks to continue the consolidation of the cloud. Increasingly, Title II reclassification looks like a done deal, and we expect widespread panic in its wake, with real risk to the future profitability of broadband. We believe TV ad revenue will follow TV ratings, with weak Upfronts in May that will be impossible to whitewash, and FB, GOOG and TWTR will benefit. We think hype on wearables and mobile payments will give way to backlash in 2H15, and that the new hype will be around connected home products. We look for the top Chinese device makers to take the spotlight, concentrating share at home and bursting into international markets at the expense of the incumbents. Security will become a big selling point for the public cloud, and AMZN, GOOG and MSFT will take more share and add value-added features on top. We are calling for a SaaS shake out, with the established players and myriad new entrants separating into winners and losers.

Last year, our top 5 stock picks were crushed by the unfortunate inclusion of S, which lost 60% of its value and overwhelmed strong performance by MSFT and STX. This year, we expect better with TWTR, TMUS, WDAY, QCOM and AMZN, all of which we believe are positioned to deliver significant upside surprises in 2015.

Go Big or Go Home

2014 was a bit quiet with regard to big strategic moves. There were a handful of spinouts to “unlock shareholder value” and plenty of tactical moves that shook up competition, but the biggest head turner was Apple’s capitulation to the appeal of big screen smartphones. The iPhone6 and its bigger brother the 6 Plus sucked the air out of the room for other device makers in 2H14, while vaulting ApplePay and the upcoming Apple Watch to obsession status with the tech press (Exhibit 1). Meanwhile, Amazon’s Fire Phone bombed. Facebook spent $20B on companies that will add nothing to its sales or earnings for years, and forced its users to adopt a separate app for messaging. Google continued dabbling in a dozen pots, bought Nest and introduced a limited delivery service, but offered nothing new with a real wow factor. Microsoft was busy with reorganization.

Exh 1: Quarterly iPhone Sales, Launch to September 2014

We expect 2015 to be quite a bit more interesting on the strategic initiative front. Google and its dozen bubbling pots is particularly interesting, as some of its dabbling may be ready to come to the front burner. Google will probably make a real splash at this year’s I/O conference in June. With Nest on board for more than a year, we expect a much more comprehensive digital home strategy – one with potential to cut through the internecine standards battles that have stymied the emergence of a comprehensive solution in the past. We also expect Google to step up its e-commerce game by connecting product discovery, advertising, merchandizing, payments and delivery into a consumer and merchant friendly platform. Ad market experts are also expecting Google to unshackle its platform to track and target consumers a la Facebook, perhaps exploring new advertising formats across its own properties in the process. Finally, Google could well be a surprise bidder for spectrum in the upcoming FCC auctions, perhaps in coordination with a network partner.

Other leaders could be busy as well. Facebook called out a sharp step up in R&D for 2015 – this could be in support of the launch of an ambitious streaming video product to compete with YouTube and others (Exhibit 2). Amazon is believed to be coming after Facebook and Google with a data-driven ad network of its own. Microsoft will offer a big OS revamp with Windows 10. We expect it to comprise both mobile and PC environments with closer integration between the two, with bold new functionality, a streamlined user interface, and powerful developer tools. It will be a big deal. Netflix could turn some heads in 2015 with live streaming and a pay-per-view tier, and could soften its rhetoric on the potential for a future ad-driven service. Apple will follow its big 2014 with a less ambitious 2015, but is likely to jump on the digital home bandwagon with a better fleshed out HomeKit platform and may elaborate on future plans to extend ApplePay and Passport into a comprehensive digital ID functionality built into all of its products and services.

Exh 2: Facebook R&D, 1Q2011-3Q2014

Digital Shopping

2014 was a big year for TMT M&A with the most deals since the 2000 bubble. Google topped the list with 35 acquisitions capped by its $3.2B deal for connected thermostat pioneer Nest. Facebook turned heads with its $22B purchase of the massive but revenue challenged messaging platform player Whatsapp and its $2B buyout of virtual reality innovator Oculus. Uncharacteristically, Apple made its biggest deal ever with the $3.2B pickup of Beats, while Microsoft surprised with its $2.5B acquisition of Minecraft publisher Mojang. Amazon joined the party by outbidding Google for video game streaming site Twitch – the $1B purchase was the company’s second biggest buy ever (Exhibit 3). The biggest single deal announced in 2014, Comcast’s play for Time Warner Cable, was held up for regulatory scrutiny and approval now seems doubtful. AT&T’s deal for DirecTV has also been held up by the FCC but appears more likely.

Exh 3: 2014 TMT M&A Deals

We also expect the big boys to have their checkbooks open in 2015, with potentially bigger targets. A number of high profile companies could draw interest. For example, if Twitter is unable to satisfy investors with renewed user growth, its $25B cap could look like a bargain given its domination of the real time news stream application and its strong ad-based monetization. Google, which supposedly made a strong play for the company pre-IPO, could certainly use Twitter’s content and strong advertising platform, while offering considerable synergy in driving registered user growth. Facebook and Amazon might also see considerable potential in Twitter, making a bidding war possible should the company come into play.

Netflix has also fallen off of its historic highs to less than $20B in cap, a price that could be irresistible to several potential suitors should it stay there. With 50M+ subs globally and growing, the company has reliable revenue streams and the largest number of recurring paid customer relationships on the Internet (Exhibit 4). Apple would be an interesting fit, with alignment on brand image and potentially reinvigorating the moribund Apple TV franchise. Google is an obvious natural buyer – Netflix would dovetail nicely with its YouTube property, IF the Justice Department would let them do the deal. Amazon, which is a distant competitor to Netflix with its Prime Video service, is a similarly obvious buyer with potentially similar anti-trust issues. Alibaba, which wears its US ambitions on its sleeve, could be interested. Netflix CEO Reed Hastings currently sits on the board of rumored streaming video aggressor Facebook, a connection which may make him more amenable to a deal, and used to sit on the board of Microsoft, which seems a less likely buyer. Finally, a traditional media player – such as Disney, Time Warner, Fox or CBS – could come out of the weeds to take a shot.

Exh 4: Netflix Streaming Subscriptions, 3Q2011 – 3Q2014

Exh 5: eBay versus Amazon – GMV per Account, 1Q2012-3Q2014

Ebay will spin off its PayPal subsidiary this year, and both parts will draw interest for M&A. While much of the chatter has concerned potential PayPal buyers, we bet that the parent Ebay will be the more likely to be bought. Ebay’s broad approach to enabling online merchandizing for traditional merchants and foothold with major retailers matches the needs of would-be Amazon competitors like Google, WalMart and Alibaba (Exhibit 5). PayPal, despite its head start in enabling e-commerce and strong growth, may be a strategic dead end, as native payments mechanisms embedded in major operating platforms – such as ApplePay, future iterations of Google Wallet, Amazon Payments, and a likely offering from Facebook, which just poached David Marcus, the president of PayPal, from Ebay – crowd it out.

YHOO is a wild card that could be an acquirer or an acquiree. With $6.3B after tax gain on its sales of Alibaba shares last quarter and with a further Alibaba stake still worth $41.5B, CEO Marissa Mayer has the wherewithal to make a deal or two in her possibly quixotic quest to remake the core company. Odds are, she won’t be shy. Since joining YHOO in July 2012, Mayer has made 47 acquisitions that included blog site Tumblr, analytics firm Flurry, and most recently programmatic ad platform Brightroll in November, and she has been forthright in asserting her intention to continue buying despite shareholder activist pressure to return the Alibaba cash to shareholders. Twitter or Netflix might be too big a bite for Yahoo, but consumer ratings site Yelp could taste right, as could rising advertising platform Pinterest. Yahoo has also been rumored as a possible buyer of TV network assets, such as Time Warner’s CNN or Scripps Media, and has been long suggested as a natural partner for AOL.

Exh 6: Alibaba Major Shareholders

On the other hand, Softbank CEO Masa Son has been cagey in responding questions about his company’s interest in Yahoo, an acquisition of which would give his company a majority stake in Alibaba while avoiding the tax hit that Yahoo would take if it were to liquidate its BABA shares (Exhibit 6). It would also consolidate the ownership of Yahoo Japan, of which Softbank already holds a 41% stake. Alternatively, Alibaba could easily raise the funds needed to buy Yahoo itself, strengthening management’s control and using the Yahoo brand as a base for its expected expansion to the US.

Turning to the enterprise, the space saw less M&A activity in 2014 than in recent years with Oracle’s takeout of MICROS at $5.3B and SAP’s acquisition of Concur for $8.3B the only major deals involving publicly traded names. For the likes of IBM, HPQ, ORCL, and CSCO, M&A deals in 2015 will be focused on shifting their businesses to the cloud and taking out some Software as a Service (SaaS) and Infrastructure as a Service (IaaS) names. With a steady IPO pipeline of SaaS names expected to continue throughout 2015, targets are abundant across nearly all cloud apps (Exhibit 7).

Our predictions: At least one of Twitter, Netflix, Ebay and Yahoo will be acquired. Google and Alibaba will each make at least one acquisition for more than $10B, which may or may not be for one of the previously mentioned public market targets.

Exh 7: IPO Pipeline of SaaS/Cloud Companies

Cable Gets a Slapdown

Just before the holidays, we wrote about Net Neutrality in our piece, “Net Neutrality: Treating the Symptoms Rather Than the Disease.” With Washington circles abuzz about reclassification, and FCC Chairman Wheeler touting the benefits of Title II with forbearance during his CES appearance, we believe this is the likely outcome when the FCC votes on proposed rules at the end of February. Designating broadband providers as Title II common carriers, even with the most onerous provisions on ice, provides the FCC with the power to step in should consumer pricing, connectivity agreements with internet content providers or network investment fail to meet its perception of the public interest. This power, even if immediately unexercised, seriously threatens the long term projections of broadband profitability currently embedded in cable and telco stocks.

This is unequivocally bad for the current broadband establishment, and we expect them to fight back, challenging the ruling in the courts and ratcheting up an already robust lobbying effort to seek legislative redress (Exhibit 8). However, we believe that the futility of this effort will be apparent, as reclassification appears squarely within the FCC’s mandate and public opinion is dramatically skewed against the industry, which carries the burden of a well reported track record of consumer abuse. We do not expect a Republican Congress to waste its political capital in protecting the business interests of Cable TV providers.

Exh 8: 2013 Lobbying Spend by Cable and Telecom Interests

Exh 9: Residential Fixed Connections by Technology

Still, the FCC’s toolbox of Title II reclassification and policy making seem limited in their ability to enact change over the real problem, which is a lack of competition. Aside from municipally led fiber initiatives including Google Fiber, there are no real alternatives to break cable’s dominance over broadband, yet (Exhibit 9). With promising wireless technologies demonstrating spectrally efficient ways of delivering speeds well above 300Mbps, we expect fixed wireless broadband will be a feasible alternative by the end of the decade. 2015 could see some major announcements for such services as the FCC’s latest spectrum auction for AWS-3 bands wraps up. Major winners will be those holding spectrum assets like DISH and S, as well as wireless patent holders like QCOM. Losers will be cable names including CMCSA, TWC, CHTR, and CVC as well as the T/VZ telecom dupoloy.

Digital Killed the TV Advertising Star

In 2014, after more than a decade of declining prime time ratings for broadcast networks, after the dramatic rise of streaming video and after clear evidence of the deteriorating quality of TV audiences for advertisers, Nielsen finally announced that the overall viewership of channelized television programming had begun to fall. We have been highly critical of Nielsen’s ratings methodology and believe that its reliance on a highly biased sample of self-selected households equipped with cumbersome technology has yielded a systematic and growing overestimation of the active audience for television. Still, inaccurate as it may be, the peak in the Nielsen benchmark is a considerable symbolic milestone for the industry.

Exh 10: Average Network Prime Time Households and CPMs, 1980-2014

Advertisers are coming to understand that they are not getting the audience or the effectiveness for which they have been paying, and we expect it will affect their spending in 2015. TV ratings continue to trend lower as consumers have a variety of options to view content (Exhibit 10). Live programming remains the only driver of appointment viewing with sports, events like award shows, and some live reality winning ratings. The days of 20M+ viewers for regularly scheduled non-sports programs are long gone with ratings for scripted content continuing to drop off (Exhibit 11). Shows like NCIS or Big Bang Theory occasionally crack the 20M mark, but only if accounting for Live+7 ratings, which account for DVR activity 7 days after an episode has aired. Otherwise, live audiences could be as much as 35% lower. Stuffing the ad pipe with more inventory hasn’t helped either with networks packing in an extra minute of commercials for each hour of programming to offset declines in spot prices.

Exh 11: Shows with average viewership over 20M viewers, by season, 1980-2014

During the most recent quarter, traditional media companies reported flat to declining TV ad sales. TWX saw flat revenue from its cable networks, while CMCSA’s cable TV unit reported a -4.6% decline. Fox’s broadcast revenue fell 5%. DIS reported ABC selling fewer ad units in the most recent quarter and CEO Bob Iger went so far to acknowledge a trend that digital has “siphoned” money from traditional TV advertising during the company’s latest earnings call. CBS only managed to grow advertising 2%, but that was because it secured rights to Thursday Night Football. CMCSA, which doesn’t break out advertising revenue for its broadcast unit, reported NBC growing topline at 7.7% higher retransmission fees, content licensing, and ratings wins. Upfronts last summer were weaker than expected, and while broadcasters still fetched modest price hikes, cable nets saw a -6% decrease in upfront commitments.

We think that 2015 will be materially worse for advertising driven television. There are clear signs that online advertising is viewed as an attractive alternative for mainstream marketers. AllState, the second largest insurance marketer with ad spend of over $600M annually, indicated it would shift 20% of its TV ad budget to digital this year. Auto companies are the largest category of advertisers in the US, spending about $10B annually across all measured media and a strong barometer of industry trends. Spending by carmakers for the bellwether Super Bowl broadcast is down this year, with VW, Jaguar, and Lincoln opting out, along with Cars.com and CarMax. Meanwhile, ratings continue on their downward trajectory. The Upfronts in May could be a serious jolt of reality after an unbroken run of rising ad prices.

The picture for TV advertising is gloomy and even observers who previously held to the narrative of TV exceptionalism have scaled back their expectations. Forecaster MagnaGlobal predicts US TV ad sales will be down -1.4% in 2015 and digital ad revenue surpassing TV by 2017, a perspective that was nowhere to be seen, even a year ago. Of course, the impact will not be indiscriminate. For example, Disney, with its diversified business holdings and its disproportionate exposure to live sports programing within its TV networks, is relatively insulated. With a longer perspective, some companies are reducing their exposure to advertising by aggressively pursuing their own digital opportunities – CBS has brought its non-advertising revenue to more than 54% (Exhibit 12). Still, we believe that it will be difficult for ad driven media stocks to navigate this inflection point without taking damage. All the while, the leading digital advertising platforms – Google, Facebook and Twitter will continue to prosper.

Exh 12: Major media company exposures to advertising

Are We There Yet?

In addition to the blockbuster iPhone 6 and 6 Plus, two of Apple’s other announcements in 2014 have enraptured the armies of bloggers, journalists and analysts following the stock. Apple Pay, in place for buyers of the new iPhone models, and the Apple Watch, rumored to hit the market at the end of March, are widely expected to kick start what had been moribund adoption for mobile payments products and wearable devices respectively. While the Apple has delivered innovative products that move the state of the art in both nascent markets significantly forward, there are considerable obstacles to adoption in both cases and we believe expectations for 2015 are well ahead of likely reality.

Apple Pay is a well-crafted solution that combines an iOS device, a fingerprint authentication and a credit-card network issued electronic token to provide exceptionally secure credit authorization for transactions in participating retail stores and online. While the technology to provide secure mobile payments has been available for quite a while, previous attempts at enabling payments at point of sale by cell phone have been clear failures due to the complexities of coaxing cooperation from the many parties with a stake in any solution. Card issuing banks make the lion’s share of fees from the payments status quo and are keen to protect that revenue stream, along with their relationships with their consumer customers. Card networks want to protect their global oligopoly over payment acceptance and their share of the fees. Merchants are bristling under the weight of payments related fees and jealously guard the insights that might be gained by analyzing their customer’s purchase patterns. Consumers are not unhappy with the current state of things, and are unmotivated to change their use of physical credit cards without a step function improvement in convenience or a meaningful reward.

Exh 13: SSR iPhone Sales Forecast (US) Apple Pay Revenue, 2014-18

Apple Pay takes care of the banks and the networks, largely protecting their fees after carving out a small slice for itself (Exhibit 13). For that largesse and for Apple’s clearly superior solution for transaction security, all of the major card brands and top issuers are enthusiastically on board, remarkable, as the financial industry had, thus far, largely fought against letting 3rd party payments brands into their party. However, this support for the current credit card fee structure is anathema to many merchants, and even though Apple has thrown them a bone with a promise to keep its hands out of the transaction data, well fewer than 20% of US retail locations support the service. Some of the nation’s biggest and most influential retailers, belonging to the merchant payments consortium MCX, have been vocally opposed to Apple Pay, with CVS going to the trouble of actually deactivating the NFC readers that had enabled the service in its stores (Exhibit 14). This problem will not be solved quickly and represents a significant obstacle for consumer adoption.

Exh 14: Merchant Customer Exchange Participating Merchants

Exh 15: iPhone 6/6+ Owner Apple Pay Utilization, December 2014

Market survey company InfoScout polled its 170,000 strong household panel in late November. Of those that owned an iPhone6/6+, just 4.6% of those that shopped at retailers that accepted Apple Pay on Black Friday actually used it, and only 9.1% of them had EVER even tried it (Exhibit 15). The assumption that Apple can easily drive adoption of services within its loyal user base may not be true – just 7% of iPhone owners use the heavily marketed SIRI, now more than 3 years after its introduction. It is not clear that Apple Pay offers consumers much return for breaking that longstanding habit of reaching for their credit cards at point of sale, particularly when the universe of merchants that accept it is uninspiringly low. We suspect that Apple’s walled garden approach will prove much more successful for online transactions, where the company may have fee advantage over many alternatives to boot. To that end, the expected launch of Apple Pay for the Safari browser in May will likely have a better pay-off for Apple in 2015 than the m-commerce version. At some point, we expect backlash against the relentless Apple Pay mobile payments hype.

The same may be true for the Apple Watch, which will enter the crowded market for smartwatches and fitness bands at the end of the first quarter. Wearables were ubiquitous at this year’s CES, but despite sharp products from almost every major consumer electronics brand, adoption has been sleepy to date. Many are looking to Apple to come in and establish the system on the wrist as the next big thing. Maybe, but maybe not.

Exh 16: Fitness Tracker Utilization

The Apple Watch will suffer from the same issue that has damped enthusiasm for Android Wear and other wearable platforms – the lack of a compelling use case (Exhibit 16). The smartphone itself has usurped the original killer app of the wrist watch, telling time, and the other applications that have suggested don’t seem compelling enough to drive broad adoption. For example, fitness – a use case promoted by Apple via its HealthKit platform – is a niche market appealing to the very sick and the obsessively healthy. Notifications on a wearable are convenient, but only modestly so compared with checking the smartphone that is in your pocket. It may be that there are geniuses out there in the developer community who will discover the app that will make a smartwatch a “must have” but that app has not come to market yet.

That said, Apple may be pursuing its optimal strategy for making a profit from the Apple Watch. It is an expensive product – starting at $349, but with higher end models with prices expected to stretch into the thousands of dollars and a range of pricey alternative bands. Undoubtedly, this premium price point will also carry a premium margin for Apple, even compared to the extraordinarily profitable iPhone, and with an average, all-in, extra bands included, customer price that could easily more than double the cheapest option, Apple won’t have to sell all that many Watches to make a meaningful boost to its earnings. That’s a good thing, because we don’t expect it to sell all that many Apple Watches.

Exh 17: Apple Quarterly Sales by Segment, 1FQ 2010 – 4FQ 2014

Some of the more aggressive analyst models out there project that Apple will sell 30-50M Watches, roughly 10% penetration into the iPhone installed base, in its first year. Given the less than compelling use case, the short window for developers to deliver independent apps, the hefty price and the lack of a carrier subsidy, we see this as unrealistic. Still, the unwavering loyalty of Apple fans and the robust global market for luxury are potent assets for Apple to exploit. We expect first year sales of the Apple Watch to be less than 10 million units, but at a price point that should exceed $700 per customer, yielding revenues of better than $7B and gross contribution to profits that could approach $4B. This is obviously nothing to sneeze at – Facebook came public in 2013 with trailing 12M sales and operating profits less than that. Still, for Apple, with FY15 sales estimated at $211B, gross profits at nearly $80B and operating profit at more than $45B, the watch will hardly be a game changer for the company (Exhibit 17). Moreover, the market for the product could saturate quickly with a MUCH slower upgrade cycle than the iPhone, suggesting a trajectory that could peak and begin to decline within a couple of years.

AAPL shares are already showing weariness in recent trading. However, we expect Apple to blow past consensus expectations for this quarter, and for the next two after it necessitating significant upward revisions for the whole of FY15 and likely driving further upside to the stock. Still, June’s WWDC product fest is very unlikely to reveal anything with the potential to drive sales like the first big screen iPhones last year, or as hype worthy as Apple Pay or the Apple Watch. This sets the company up for nearly impossible compares for next September and thereafter, and for a return to the sort of hype-weary investor malaise that weighed on AAPL in 2013.

Exh 18: Connected Home Device Unit Shipment Forecast, 2013-2020

Getting Beyond the IoT Standards War
Just as payments and wearables drove the 2014 hype cycle, the “Internet of Things” or more specifically, the “Digital Home” is ready for its turn at the front of the peloton (Exhibit 18). The race to connect elements of home living to the internet has been long bogged down by dueling technical alliances and by the proprietary approaches of individual manufacturers, with ambitious companies each hoping emerge as the standard and working hard to make sure that no one does in the interim. This cacophony of voices was apparent in the sprawl of IoT devices at this year’s CES, where nearly every major exhibitor featured their own approach to connecting the home.

In 2014, the two biggest device platforms – Apple and Google – each made relatively unheralded moves to cut through this murk. Seemingly switching traditional strategies with one another, Google made a hardware move by taking out privately held Nest, while Apple published its HomeKit software API, inviting 3rd parties to piggy-back on its iOS platform strategy. We expect both to gain momentum in 2015, with neither really winning the day but generating enough buzz to be this year’s wearables or mobile payments.

Under Google’s umbrella, Tony Fadell, the founder of Nest and the erstwhile iPod design and engineering guru at Apple, has autonomy over the digital home business and continues with his distinctly Cupertino-ish approach to devices – initially thermostats and smoke detectors – designed to the teeth and intended to completely leapfrog traditional home control solutions with fresh new system ideas. However, Google’s clout, with its billion plus Android devices in the field, will help drive a new program, called “Works with Nest,” intended to build support for inter-compatibility across the industry. Initial Works with Nest partners include Mercedes-Benz, Whirlpool, LG, Chamberlain, which makes garage doors, and Lutron, a light switch maker. Nest has also signed up smaller startups like August locks, Zuli smartplugs, and Stack smartbulbs.

AAPL, on the other hand, is taking a very GOOG like approach with its HomeKit platform for third parties to adopt and create devices that can talk to AAPL’s core line of iPhones, iPads, and Macs. While HomeKit compatible devices were showcased during CES, the program is still a work in progress with no products conforming to AAPL’s rigorous standards yet on the market. Of the HomeKit compatible smartoutlets, garage door openers, light bulb adapters, door locks, and power strips showcased, none are MFI (Made for iPhone/iPad/iPod) certified. The standardization process for HomeKit and some product requirements such as AppleTV for Siri compatibility, could weaken AAPL’s attempt to control the home. So far, GOOG, with its popular Nest products and looser compatibility standards appears to be ahead.

Beneath these platform efforts, the battle over interconnection standards continues at the semiconductor level, with the Qualcomm derived Allseen Alliance specifications up against Intel’s Open Interconnect Consortium, each looking to marry coding across multiple wireless technologies including WiFi, Bluetooth, LTE, and home specific standards like Zigbee and Z-Wave (Exhibit 19). It’s important to note that neither AAPL nor GOOG are specifically backing either effort. Microsoft threw its hat in with Allseen, after Qualcomm signed over its “Alljoyn” source code to the non-profit Linux Foundation, which now oversees the Alliance. Qualcomm is betting that it can make its money on selling the chips that will connect devices in the Internet of Things, rather than collecting royalties. With Qualcomm’s jump-start, the Allseen effort has at least a 3 year lead over the Open Interconnect Consortium, which was just founded this past summer by Intel with anchor members Samsung, Cisco, MediaTek, and GE. Broadcom left the alliance late last year due to differences over treatment of IP. Not much is yet known about the consortium’s specifications, but its membership roster is smaller and several key players (ADT, Cisco, Lenovo, and CableLabs) are hedging their bets by belonging to both organizations. Given all of this, we see Allseen as the likely long term winner.

Given smartphones and tablets running on Android or iOS platforms will be the control element of most home automation and IoT accessories, the platforms will have a lot of power in setting the course of device interconnection. As with wearables, the payoff is still a few years out, but we expect decisions made by stake holders later this year to make the pathway forward much clearer.

Exh 19: Internet of Things Standards Bodies and Memberships

China Rising
China’s fledging device makers are no longer purely domestic businesses. Homegrown device makers like Xiaomi, Huawei, ZTE and Lenovo have not only begun to assert their control of the Chinese market, booting international incumbent Samsung from the top spot domestically, but setting their sights on international markets. Chinese handset makers, by reputation maniacal when it comes to controlling costs, began to deliver devices with excellent design and build quality over the past couple of years, rivalling the flagship models of global leaders like Samsung and Apple, but at dramatically lower prices.

Xiaomi is particular challenge for those supposedly entrenched brands. The world’s fastest growing major handset maker sells its phones at near the cost of materials while capturing some profits on sales of software and accessories. The company doesn’t advertise and it distributes handsets through its online channel and several branded retail stores. The fact that it sold more smartphones in China than any other player over the past couple of quarters and ramped up to over 60M handset shipments in 2014 is staggering, especially given the company was only founded three years ago (Exhibit 20).

Though Huawei and ZTE have been shipping private label smartphones to markets outside of China for several years, smartphone shipments outside of China by indigenous vendors have grown 118% in the past year to over 62M units shipped outside the country from the big 4 (Exhibit 21). Rising star Xiaomi poached Google’s Hugo Barra in 2013 to lead international expansion and sold its first phones outside China in 2014, though only 4-5% of the company’s handsets were exported in 2014. A $1.1B capital raise in December from a consortium of investors that values the company at $45B will facilitate the expansion, which will likely focus on other emerging markets where price is an important consideration for consumers. Lenovo, already established in international markets via its PC business, snapped up the venerable and suddenly chic again Motorola brand from Google in 2014 and appears poised to move aggressively in 2015.

Exh 20: Smartphone Shipments in China by Vendor, 1Q12 – 3Q14

Exh 21: Chinese Smartphone Exports, as % of company shipments

Aside from Xiaomi, Huawei, ZTE and Lenovo, there are other Chinese handset makers growing and likely to look beyond China for opportunities. Yulong/Coolpad, OPPO, BBK, Gionee, and Tianyu can all claim momentum as the Chinese domestic market continues to consolidate from the chaos of its many dozens of tiny wannabe manufacturers. We note that export ambitions and industry consolidation will have beneficial effects for Qualcomm as it negotiates settlement with Chinese regulators and reins in the non-payment of royalties by scofflaws. All of the big boys in China have signed their patent licenses and most of them are doing business with Qualcomm for at least some of their chips as well.

As we expect the controversy around Chinese IPR royalties to settle, we see Qualcomm and its archrival Mediatek as the best ways to play the Chinese smartphone incursion. On the flip side, none of this is good for Samsung, LG, HTC or even Apple.

To Boldly Go Where Everyone Else Seems to Be Going

The big knock on the public cloud has always been security. Every article on the cloud would quote some CIO metaphorically wringing his/her hands with some version of “I just don’t know if I can trust Amazon, Microsoft or Google with my precious data” as a justification for keeping everything in house. As we closed 2014, after devastating criminal hacks at Sony Pictures, Target, Home Depot and JP Morgan Chase, that justification rings increasingly hollow.

Enterprise IT departments are not home to the best and brightest cybersecurity minds outside of the NSA. They do not invest in intrusion detection, ubiquitous encryption and other anti-hacker defenses as a primary business need. They don’t restrict systems access to a need to know basis and they don’t police the behavior of their employees to assure sensitive data bases are watertight. The top public cloud companies – specifically Amazon, Microsoft, and Google – do all of this. Yes, the public cloud has suffered its share of hacker attacks, as the black hats go after their white whales, but the end results have been denial of service, not intrusion and definitely not theft.

Exh 22: Top Challenges in Shifting to the Cloud, December 2014

In 2015, we believe we will see the public cloud giants using security as a prime selling point and enterprises buying for the same reason (Exhibit 22). IT managers will understand that a devastating hack on a system that they control in house is a career altering event, but that an attack on a cloud partner is someone else’s fault and that, likely, many other enterprises will be in the same boat. With this, the major data center migration of the cloud era will begin in earnest, one that we believe will eventually comprise the vast majority of enterprise computing.

With security suddenly an asset, the cost advantages of moving to the cloud will be “no brainer” compelling. Our analyses suggest that for many applications, public cloud hosting may be less than 1/8th the all-in cost of in-house data centers, a gap that is widening in the midst of a significant Google-led price war in the IaaS market (Exhibit 23). In this context, enterprises will begin decommissioning uncompetitive data center operations, will curtail investment on in-house IT assets, will weigh hosted SaaS alternatives to their existing applications, and will start executing plans to transition existing applications to public cloud hosts. This is good for IaaS hosts, good for the SaaS application market, and unequivocally bad for traditional IT hardware and software vendors, who will see their life blood squeezed in a migration that will be fundamentally deflationary for overall IT spending. While this transition will take many years to fully play out, the directional impact has been already apparent in the sales of data center systems and software and will intensify in 2015.

Exh 23: Basic On-Premise versus Cloud Cost Comparison

The IaaS price war is also likely shake out many weak hands amongst the sub-scale also-rans of the hosting market, a group that is essentially all competitors that are not Amazon, Microsoft or Google. Expect the price war to continue, and expect 2-3 high profile changes in strategic direction for the cloud hosting efforts of traditional IT vendors (IBM, HP, Oracle, EMC, VMWare, etc.), network carriers (Verizon, AT&T, CenturyLink, etc.), data center real estate players (Equinix, etc.) and start-ups. In the long run, very few of these sub-scale operators will survive this business. Eventually, this will be very good for Amazon, Microsoft and Google, who have very attractive opportunities to layer money-making value-added services atop their largely commodity infrastructures. The growth will be very apparent this year. The profits will come later.

The SaaS Shake Out

The first round of SaaS application companies came of age during the millennial Internet bubble. Companies, like Salesforce.com and NetSuite, wrote well-crafted applications and implemented them on their own internal data centers. The pitch was a superior application, free from support costs and automatically upgraded, accessible by employees via the internet. Salesforce.com was particularly successful, due, in part, to the peripatetic use of its excellent customer relationship management (CRM) application by sales representatives in the field, which amplified the value of an internet based solution.

Exh 24: Worldwide SaaS Forecast, 2013-2017

A new era of SaaS is rising now. The sharp decline in the costs of IaaS hosting has saved would be applications start-ups the expense and trouble of building out a private data center, thus, dramatically lowering the barriers to entry (Exhibit 24). A flood of new venture backed startups have entered the fray, most of which remain private in the aftermath of the multiyear post-financial crisis hold up in tech IPOs. Since the 2013 Facebook debut, the backlog has been starting to thin (9 SaaS companies IPOd in 2014), but dozens of enterprise SaaS application companies remain in the IPO queue.

Wall Street battered SaaS stocks across the board in the first half of 2014, dissatisfied that so many remained unprofitable, and the recovery has been spotty but still, somewhat indiscriminate. We believe that 2015 will see these names trading more independently, with clearer winners and clearer losers. We see older established companies, like CRM and NetSuite, as a bit vulnerable to top-line deceleration and tighter margins as aggressive new entrants use the cost and flexibility advantages of public cloud hosting to undercut them on price. We see some new entrants, in particular the storage plays Box and Dropbox, as poorly positioned to compete long term, and possibly facing icy receptions to their planned IPOs. We see other players as offering important innovation in their applications and enjoying the cost implications of the IaaS price war. Here we have included Tableau Software and WorkDay in our large cap model portfolio, and Marin Software, Opower, ZenDesk and Proofpoint in our small cap portfolio (Exhibits 25-26).

Exh 25: SSR Large Cap TMT Model Portfolio

Exh 26: SSR Small Cap TMT Model Portfolio

How Did We Do?

Grading our 2014 thematic predictions, more were on target than not, with a couple of A’s for prognosticating digital ad growth and the emergence of new SaaS names to challenge incumbents, and a couple of weak C’s for getting overexcited about the timing of wireless residential broadband and for thinking that Sprint could join T-Mobile in taking market share from AT&T and Verizon. The rest were solid B’s, mostly directionally correct but a bit early (Exhibit 27).

The As: Our call on the acceleration of digital ad growth with video, mobile and social driving the upside was spot on. Strong ad sales growth from GOOGL, FB, and TWTR confirmed this throughout the year and we see more coming in 2015. We also predicted a flood of new SaaS names would emerge, and they did with 9 IPOs last year. The pipeline for SaaS IPOs continues to be healthy and we expect the trend will continue into this year.

The Bs: Some of our calls were either partially correct or still a little early. The mixed outcome has us grading these predictions as Bs. Our call that Samsung and AAPL would lose share to indigenous Chinese players and MSFT was partially right. Samsung has been flailing to keep share and indigenous Chinese names like Xiaomi have had banner years. Though AAPL lost smartphone share in the first three quarters of the year, the strong iPhone 6/6+ offering should claw that back by year end. Also, MSFT is playing its cards carefully with phones, avoiding high margin flagship devices and focusing on emerging markets where Nokia was once strong. Unit volumes are hanging in, but value share is sliding. Meanwhile, the Surface Pro 3 has been a pleasant surprise on the tablet side.

Exh 27: 2014 Prediction Report Card

We predicted little progress on patent conflicts leaving IPR law firms as the only winners. Here, we didn’t go quite far enough. Yes, the IPR law firms had a big year, but software patent holders suffered substantial rebukes by US courts. Key patents in the bellwether Apple/Samsung case have now been invalidated upon examination by the patent office and the lurid $1B jury award has already been reduced by the judge on the case, even as the appeal teeters its way toward a likely further revision in favor of Samsung. As the “thermonuclear war” declared by Steve Jobs fizzling, Apple and Samsung agreed to withdraw their lawsuits outside of the US. Likewise, the Rockstar Consortium, an IPR joint venture owned by Apple, Microsoft, Blackberry, Ericsson and Sony, quickly settled patent suits that it had brought against Google and Cisco. There are still several important cases up in the air: Qualcomm in China, Oracle’s API copyright case against Google that is headed to the US Supreme Court, and of course the final resolution of Apple – Samsung.

We also predicted the move to online video would starting hitting MSOs and television network bottom lines. This is partially right as the American TV audience has clearly peaked. Audiences are declining and advertisers struggled to pass on price increases at May’s Upfront presentations. Most TV network owners have reported weak recent ad sales and there has been a modest pick-up in cord-cutting, but while media and cable stocks were taken down a peg in 2014, the impact has not really been felt on the bottom line … yet.

We believed that mobile payments and on-line payments in the cloud would remain in a status quo holding pattern, which would give false confidence to the traditional payments players, in particular, the issuing banks. Those players do have false confidence, but one born of Apple’s willingness to preserve their role and their fees in Apple Pay. Apple Pay has gained more attention from the blogosphere than it has from iPhone users, and we think there is a long row to hoe before mobile payments really take off. We do think that platform-based mobile/electronics payments solutions will eventually be ubiquitous, and that when they are, the traditional credit card industry will be badly damaged, but that day is years in the future.

Our prediction that enterprise IT’s ongoing move to the cloud would disproportionately benefit the major web scale hosts Amazon, Microsoft and Google, was largely correct, save for the Google-initiated price war that was wildly deflationary for industry revenues and sapped the margins of all players, especially the market leader Amazon. Still, the pain was far more acute for the industry’s also-rans, forcing companies like Rackspace to reconsider their ambitions and highlighting the futility for traditional IT players looking to keep pace on data center costs.

The Cs: Our wireless predictions were premature. We jumped the gun on the idea that the market and investors would begin to accept the potential for wireless networks to effectively compete for residential broadband service by the end of the decade. Technical trials of equipment based on the LTE Advanced standard Release 12 at the end of 2014 demonstrated the feasibility of 450Mbps download speeds using just 60MHz of spectrum, with a rough 8 fold increase in the total capacity available in each cell site. Commercial deployment of this equipment can begin by the end of 2015, with the next release of the standard, promising further improvements due just two years behind. This technology trajectory puts wireless operators on track to begin undercutting the fixed broadband oligopoly by 2020, but outside of Charlie Ergen and Masa Son, no one in the industry is yet willing to talk about it. We are taking a more patient approach with this idea in 2015 – broadband operators will have enough to deal with this year.

We were also far too inclusive in our prediction that Sprint and T-Mobile would grab market share at the expense of AT&T and Verizon during 2014. T-Mobile, led by its charismatic and sometimes outrageous CEO John Legere, more than met our expectations for aggressive price cuts and customer-friendly service changes that grabbed tons of new subs and forced competitors to follow. However, most of those new T-Mobile subscribers were taken from sad-sack Sprint, which struggled to deploy its new LTE network and underperformed expectations on any metric, network or financial, you might care to choose. Yes, AT&T and Verizon were shaky in 2014 as predicted, but absorbing that 60% decline in Sprint shares in our large cap model portfolio makes this one no better than a C.

This Year Will Be Better Than Last Year

Our top picks for 2014, Microsoft, Seagate, Qualcomm, Google and Sprint, were down an average of 2% for the year. Sprint was the culprit, as it fumbled its LTE roll-out and continued to bleed subscribers on its way to a crushing 60% decline. We had believed that a shift in consumer priorities toward data service would advantage smaller carriers at the expense of market leaders AT&T and Verizon, and we chose Sprint because we believed that it had superior spectrum assets. Bad choice – T-Mobile led the way in innovation and share gain, while Sprint continued to execute like Sprint. This year, we are shifting our support to T-Mobile, which not only has flipped its image with consumers but could see the M&A rumors that continue to swirl around it play out in 2015 (Exhibit 28).

Google swan dived on its 3Q15 earnings on fairly speculative concerns about its ability to sustain its cash-cow search advertising franchise and has yet to recover. We were tempted to double down for 2015, as we expect big strategic moves in 2015 and remain convinced that it is the company best positioned to exploit the opportunities being created in the cloud era. Still, the big strategic moves could include a big acquisition or two that might be viewed negatively by investors and its most intriguing initiatives may not pay off quickly enough to move the needle now. Instead, we shifted to Amazon, which we took out of our large cap model portfolio in October because we felt that CEO Bezos would only move to deliver profits when the stock performance began to hinder his ability to retain employees. With the share price off more than a third, that day is coming and we expect the quarterly surprises to tip back to the positive side sometime this year. That is enough to convince us to include it on the list.

Microsoft was our best performing pick, up 29% for 2014, and remains well positioned for 2015. We continue to expect excellent performance from new CEO Satya Nadella’s crew, but the outperformance last year takes from the potential upside this year. We see more of that upside available from SaaS HR and Financials application leader Workday. We believe investments in data analytics products and an embrace of 3rd party hosting will pay off, with the potential for better than expected topline growth and margins to catalyze a significant upward move in 2015.

Seagate was an excellent performer in 2014, up 23%, although we chose the wrong competitor in the group, as rival Western Digital was up an even more impressive 36%. Our thesis, that demand from cloud storage would offset declining PC units and that the newly concentrated industry could maintain reasonable pricing discipline, largely played out and both Seagate and Western Digital remain relatively cheap and attractive investments. However, for 2015, we see more upside from Twitter, one of the more controversial stocks in TMT. We have written extensively on Twitter (link) and believe that its core value as an advertising platform is considerably underappreciated by investors that have fixated on the single metric of registered monthly active users. We see three ways for this stock to work in 2015. First, those registered MAUs could surprise to the upside – a strong possibility given improvements to the onboarding process, the growing visibility of the service in global media, and the potential for outreach marketing to confront user misconceptions and make clear the use case. Second, Twitter could decide to replace unpopular CEO Dick Costolo with a leader better able to articulate the company’s value and execute its forward strategy. Finally, should Twitter continue to straggle, its unique real-time content distribution capability would be immensely attractive to deep-pocked potential acquirers, like Google, who could resolve that lingering user problem in a snap. Any of these factors could drive Twitter stock 50% higher and we see them as much more likely than not.

Finally, we have decided to keep Qualcomm as our single holdover from last year’s picks. The stock treaded water in 2014, ending the year up 1% from where it started after taking a downward tack in the second half upon its acknowledgement of difficulties in collecting royalties in China in the midst of that country’s regulatory investigation. We believe that the resolution of the Chinese inquires, in negotiation now, will prove to be less onerous than the most bearish observers have feared, given the support of the country’s biggest domestic handset makers. Moreover, those big device players, Xiaomi, Huawei, ZTE, Lenovo, etc. – Qualcomm IPR licensees and chipset customers all – are poised to quickly consolidate domestic market share and move aggressively to the export market. This is very good news, given Qualcomm’s struggles to collect from the struggling smartphone startups that still make up a good piece of the Chinese market.

Exh 28: 2015 Winners and Losers

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