Ten Investible Things that We Think Will Happen in 2016

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SEE LAST PAGE OF THIS REPORT Paul Sagawa / Artur Pylak

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January 20, 2016

Ten Investible Things that We Think Will Happen in 2016

2015 was a big year for TMT. AMZN and NFLX more than doubled, GOOGL popped 40%, while AAPL lost nearly 25% from its all-time high set in March. Our beginning of the year predictions were more right than not, nailing the inflection point for linear TV, the break out of the public cloud, the slow start for wearables and mobile payments, and the hype around the Internet of Things (IoT), and directionally correct on the relative success of Chinese device makers and a SaaS shakeout. Our top five picks for the year were a mixed bag, with the spectacular success of AMZN and TMUS offset by the inclusion of the worst performing stocks in our model portfolio – TWTR, QCOM and WDAY. We revealed our 3 best long (GOOGL, MSFT, and TWTR) and short (ORCL, JNPR and IPG) ideas for 1H16 last week (http://www.ssrllc.com/publication/tmt-the-longs-and-shorts-of-it/). Our predictions for 2016:

  1. More Pain for Linear TV – Pay TV cord cutting will accelerate, as streaming services add ever more attractive programming and MSOs hike prices. Ratings for broadcast and cable shows will continue to disappoint, and advertisers will shift their budgets toward digital. This will be apparent in cautious commitments during the May Upfronts. The Olympics and a raucous campaign season will partially offset the structural deterioration of the linear TV ad model, but industry revenues will still disappoint.
  2. A Crack in the Broadband Armor – Zero rating for video on TMUS could convince young demographics to drop residential broadband, drawing attention to the assumption that cable MSOs can raise prices and cap usage forever. Between TMUS, Google Fiber, Sprint’s residential ambitions, new spectrum auctions, the emerging 5G standard and the possibility of further regulation, long-term forecasts for fixed broadband service revenues and profits will be called into question.
  3. The Cloud Eats Security – Hacking will get worse, and the conversation will shift to the advantages of SaaS and IaaS vs. private data center security solutions. Sophisticated proprietary solutions, disciplined security protocols and industry best talent make AWS, Azure and GCE much more secure than the commercial firewall and data encryption software employed by enterprises. As a result, the herd of high multiple security vendors will see more disappointments and sector valuations will be pressured.
  4. Devices Disappoint – The global market for premium smartphones is largely saturated and attempts to juice already historically high replacement rates won’t work – 2016 sales will be down. Tablet sales already turned down in 2015, with the most promising area for new growth coming from Windows 10 devices to be sold into the enterprise market. The functionality of wearables is still far too narrow to make the category more than a small niche market. All of this is bad for device makers and their suppliers, who will disappoint investors hoping for even modest growth.
  5. Online Travel Gets a Reality Check – The internet has been brutally efficient in cutting middlemen out of transactions. An exception to the rule has been Online Travel Agencies, where PCLN, EXPE, TRIP and SABR have grown rapidly and profitably fronting for airlines, hoteliers and car rental services. 2016 could see challenges for the group. Travel suppliers, unhappy with fees taken by the OTA middlemen, are beginning to make lower prices available when reservations are made directly. We also believe OTAs may be more vulnerable to tools offered directly by mobile platforms. AMZN may have shuttered its Destinations product, but OTA margins look too high for Jeff Bezos not to take another swing. Finally, the growing popularity of alternative accommodation services, like AirBnB, threaten the most lucrative piece of the OTA business.
  6. Car Talk – 2015 saw electric and autonomous vehicles moved to the front burner, as would-be disruptors like TSLA, GOOGL, AAPL, Uber and brash new kid Faraday teased the market with their future visions. Now incumbent car makers have joined the chorus, and 2016 will see lots of headlines, as alliances form and plans solidify. However, none of it will translate into real revenue or profit this year. In the longer term, we suspect GOOGL, with its 6 years and million+ miles of driving data, has the technical lead for truly autonomous cars, despite big talk from would-be rivals.
  7. Big Guys Win – The most lucrative opportunities in TMT are already fairly concentrated. AMZN and MSFT have almost half of the public cloud market. GOOGL and FB control more than half of digital mobile advertising. AMZN has over a third of US e-tail sales. NFLX and GOOGL’s YouTube serve 75% of streaming video traffic. We expect all of these players to gain share in 2016 and surprise against surprisingly modest expectations. Worries that these big winners from 2015 may have peaked will prove entirely unfounded.
  8. Finally some M&A – A few chip makers announced deals in 2015 – INTC/ALTR, AVGO/BRCM – and Dell is buying EMC, but the biggest names were uncharacteristically quiet. We expect GOOGL to shop for a bigger m-commerce presence, FB to bulk up in content distribution, and MSFT to roll up SaaS applications for its cloud platform. We also expect old school IT players to overpay for cloud presence and to seek combinations with each other.
  9. New Bidders Drive Spectrum Auction Upside – The FCC’s incentive auction of TV spectrum will take more than 6 months, attract more than 90MHz of spectrum, and generate more than $60B in spending. We expect at least 1 consortium of non-traditional bidders to win spectrum, with GOOGL, and CMCSA expected to participate, although not necessarily together. TMUS will buy the biggest chunk, but T and VZ will be more active than they have suggested.
  10. Our Picks – Last week, we highlighted GOOGL, MSFT and TWTR as our top picks from our 15 stock large cap model portfolio. We also chose ORCL, JNPR and IPG as our favorite short ideas, this time from our 15 name short portfolio. We believe that these ideas are very likely to play out over the next 3-6 months.

How did we do Last Year? Out of 10 predictions, 5 were spot on. TV advertising did roll over for digital, wearables and mobile payments disappointed, the public cloud (AWS and Azure) surprised, Chinese device makers took tons of share, and the SaaS market saw big winners and losers. We can only take partial credit for the rest. The big TMT names – AAPL, GOOGL, AMZN, FB, MSFT and NFLX – didn’t do as many cool things as we had hoped. Outside of the chip sector, there wasn’t a lot of M&A. Broadband was reclassified, but not much happened as a result. Little progress was made toward digital home or IoT standards. Finally, our stock picks were a mixed bag – AMZN and TMUS were great, WDAY, QCOM and TWTR, not so much.

Exh 1: The SSR TMT Heat Map

New Year? New Predictions

2015 was another year of big change for TMT investors. AMZN pulled the wraps off AWS to reveal a high profit juggernaut, overshadowing a big reacceleration in its core shopping business. NFLX blew past subscriber growth expectations, and sucked away precious viewing hours from linear TV. DIS revealed that ESPN’s sub numbers have been dropping for two years, sending the whole media sector into a late summer tailspin. Google became Alphabet (but remained GOOGL), promising more transparency, while its YouTube business drove growth and its autonomous car project drove headlines. MSFT’s cloud delivered big growth to go with a very successful Windows 10 launch. TMUS harvested swaths of market share on the strength of its “Uncarrier” strategy. AAPL underwhelmed with its watch and its iPhone 6 follow on.

We managed to get a lot of that right – hence the 1410 bp outperformance in 2015 of our large cap model portfolio vs. the tech elements of the S&P 500 (Exhibit 2-3). We called the inflection point for linear TV, the ho-hum response for wearables and mobile payments, and the big reveal for the extraordinary growth of the public cloud. We were more or less right about the rise of Chinese device makers, and about the shake out amongst the dozens of public SaaS application vendors. On the other hand, we were a bit over enthusiastic in calling for big strategic moves and deal making by the cloud elite. We were right that the FCC reclassified broadband as a Title II telecom service, but wrong in assuming that it would make much difference. The same is true about Internet of Things hype – little progress was made in establishing workable standards. Finally, our top 5 stock pics were a real mixed bag. AMZN was a grand slam and TMUS was a big hit, but WDAY, QCOM and TWTR were the worst names in our model portfolio (Exhibit 4).

Like last year, we are looking to take a bit of counter-consensus risk with our predictions. We think that the pain is far from over for linear TV and look for media companies to take another major leg down in 2016 on accelerating cord cutting and audience deterioration. We think that the assumption of perpetual broadband domination will come into serious question, with the appearance of pressure from wireless, new fiber projects and regulation. We expect that the bloom will come off of the rose for security software vendors as enterprises begin to look to the cloud for help against a rising tide of hackers. Demand for devices – smartphones, tablets, wearables, etc – will be slack, and the value chain disappointments will last all year and then some. OTAs will start to get squeezed between vendors, platforms and alternative to traditional lodging. Autonomous electric vehicle hype will grow tiresome, but GOOGL will quietly take big steps toward eventually launching transportation as a service. In all of the important markets – IaaS, e-Commerce, streaming media, etc. – the leaders will extend their leads, and the big platforms will integrate more functionality. We expect more M&A than we saw in 2015, with GOOGL, FB, and MSFT in the middle of big deals and lots of weak hands shopping in desperation. We think TMUS will be the big winner in a spectrum auction that will stretch 4Q, and that GOOGL and CMCSA will show up as parts of separate non-traditional bidding consortia.

We hope to do better this year with our top picks. GOOGL, MSFT and TWTR all have material upside and natural catalysts that should drive strong appreciation over the next few months. On the flip side, we see ORCL, JNPR and IPG as particularly ripe for disappointment. We will check in with these picks when we make our quarterly adjustments to our model portfolios

Exh 2: SSR TMT Large Cap Portfolio Performance – 2015 Summary

Exh 3: SSR TMT Large Cap Portfolio Performance – Relative vs. Benchmarks past 12 quarters

Exh 4: SSR 2015 Prediction Scorecard

More Trouble in TV Land

Media stocks seem to have finally gained their feet after a 3Q15 tumble catalyzed by Disney CEO Bob Iger’s unusual candor in owning up to sub losses at his company’s lucrative ESPN network. The net damage was considerable – save for Iger’s Disney and the cable conglomerate Comcast, both of which have significant other sources of sales and earnings, the biggest owners of cable and broadcast networks were all down double digits (Exhibit 5). CBS suffered the least damage, down 15.5%, and Viacom suffered the most, down 45.3%, and the rest were all off between 23-28%.

Media analysts expect the group to start to climb. Historically, Presidential election years, which coincide with the summer Olympics, have driven strong advertising results for the TV networks. Consensus sales forecasts for the group reflect this, with growth expected in a range of 3.1% (for Viacom) to 11.2% (for Scripps) and revenues for the owners of the major broadcast nets – CBS, Fox, Disney and Comcast – are forecast up 5 to 8%, in keeping with the normal impact of the quadrennial pattern (Exhibit 6).

Exh 5: Media Stock Performance, August 2015

Exh 6: Consensus Expectations for Media Stocks, Next 12 Months

Except the current circumstances are anything but normal. Total linear TV viewing has been falling for 6 years, a fact evident to streaming video providers but masked to traditional media, ad agencies and their customers by Nielsen’s TV-friendly methodology. Cord cutting is picking up and would-be viewers in Pay TV households are shifting their attention to streaming alternatives. The May Upfronts were historically weak, and only a $300M+ influx of spending from fantasy sports betting sites kept the scatter market healthy during the fall season amidst ratings disappointments everywhere (Exhibit 7).

Exh 7: Fantasy Sports Ad Spending, 2015

We believe the core demand for TV ads will be down in 2016, following continued linear TV audience deterioration. We believe the legally beleaguered fantasy sports betting industry will have to drastically cut back its advertising. We expect the 2016 Upfront sales to be disappointing. We believe Pay TV sub declines will be worse than most people expect. We believe election and Olympic spending will create a bit of cover, but that overall hopes for a 6-8% bump in linear TV ad sales will prove very optimistic.

Wait … Cable Broadband Faces Risks?

Total US Pay TV subs have been declining for two years (Exhibit 8). TV networks have demanded and won fee hikes that squeeze cable margins and force service price increases that will only encourage more cord cutting. Why then do cable companies trade at premiums to their TV media counterparts and why do analysts expect them to keep growing and expanding their margins?

Broadband. For 60% of Americans, the monopoly cable operator is their only choice for internet access fast enough to support high quality video (Exhibit 9). A recent essay by Harvard Law Professor Susan Crawford on Medium (https://medium.com/backchannel/big-cable-owns-internet-access-here-s-how-to-change-that-131fe62cd98f#.7f1h6ehaw) quotes a well-known Wall Street analyst as projecting cable MSOs as winning 90% of the market where the sole alternative is copper-based DSL technology, and a majority where fiber-based alternatives, like Verizon’s FiOS, are available. As a result, according to The Open Technology Institute’s Cost of Connectivity annual report, broadband prices in US cities are 25-30% higher on average than in European cities for all but the very lowest speed (sub 6 Mbps) offerings (Exhibit 10). The OECD reports that on a dollars per megabyte basis, the mid-point of the US range of prices is the second highest of the 33 countries in their 2014 survey (Exhibit 11). Add in that cable operators report 90%+ margins on internet access. Considering all of this, and the Wall Street assumption that it can continue indefinitely, and the valuations for cable stocks start to make sense.

Exh 8: US Multichannel Video Customers, Q107-Q315

Exh 9: Broadband Competition at Key Service Thresholds

Exh 10: Average Speed for Broadband Plans Priced Between $35 and $50

Exh 11: Fixed Broadband Prices per Mbps of Advertised Speed, 9/2014 USD PPP

But what if residential broadband prices don’t stay sky high forever? We believe competition will come from wireless networks. Pew Research reports that the percentage of US adults with residential broadband service actually dropped from 70% to 66% over the last two years, with the percent relying solely on their wireless service for internet access rising from 8% to 13% over the same timeframe (Exhibit 12). A WSJ article, from December 31, notes that Softbank Chairman Masa Son pressed the potential of Sprint to compete for residential broadband during FCC hearings before his proposed merger of Sprint and T-Mobile was rejected. Dish CEO Charlie Ergen has noted the same possibility. T-Mobile has taken it a step further by offering free streaming of most online video services, albeit at a modest 480p resolution, to its mobile customers.

Exh 12: U.S. Home Broadband Adoption, 2000-15

The real breakthrough will likely come with the 5G standard, expected to be commercialized in 4-5 years. The new standard will allow disparate frequency bands to be easily combined to provide bandwidth in channels varying from less than 1Mbps for IoT connectivity to hundreds of megabits a second, all with much greater spectrum efficiency and much lower latency. To top it off, 5G will likely accommodate a new network architecture that moves most processing tasks to centralized data centers, reducing the equipment needed at each cell site, and thus, the capital costs of network expansion. This will be further aided by very low cost small cells, which can expand capacity into neighborhoods without requiring towers at all.

Moreover, many pundits and investors may be overestimating the bandwidth needs of American households. An HDTV stream requires roughly 6Mbps and a 4K video stream needs about 37Mbps (Exhibit 13). A new compression standard should cut those requirements in half over the next couple of years (Exhibit 14). Given the slow spread of 4K capable devices and content, 100Mbps is probably plenty of bandwidth for the typical household, as long as it is consistently available. A similar phenomenon played out in enterprise networking in the ‘90s, when 1 Mbps Ethernet gave way to 10 Mbps Ethernet and then to 100 Mbps Ethernet in short order, driving regular replacement of desktop PC networking cards and strong growth for networking card leader 3Com. When 1 Gbps Ethernet was introduced in 1998, it was assumed that another major upgrade cycle was in store, but it never happened. 100 Mbps was enough for all but the very fastest enterprise applications and the progression stalled. We believe the same may be true for residential broadband, and this will make it much easier for wireless alternatives to compete.

We suspect that the thesis of wireless competition for residential broadband will become more widely acknowledged in 2016. We also note that a new Democratic President would likely push tighter enforcement of net neutrality and could press the Democratically controlled FCC to employ its powers to regulate broadband as a Title II telecommunications toward lower prices for consumers.

Exh 13: Throughput Requirements by Application and Select Compression Technologies

Exh 14: Wireless and Wireline Advances, 2000-2020

Revenge of the Nerds

2015 began with Sony Pictures in the midst of an embarrassing and costly hacking scandal. Over the course of the year, hackers broke into the US Office of Personnel Management to steal millions of government employee records and into extramarital affairs site Ashley Madison to expose its clients, amongst a laundry list of less headline worthy enterprise security failures. Against this background, it seems obvious to expect those companies that sell enterprise security software to be enjoying a booming market for their wares.

Wall Street certainly has taken that stance. There are 11 US traded companies with market caps of $1B or more that specialize in security software, and a number of broader IT technology players, like Cisco, Juniper, and others, that have identified security solutions as a major line of business. Analysts expect the specialists to collectively grow 15.3% this year, and the market has assigned these companies an average 4.9 times sales multiple, despite average operating margins of just 3.8% (Exhibit 15).

We are not convinced. The basic model for enterprise security solutions is fairly consistent across the various software vendors. Enterprise networks are protected by firewalls intended to identify unauthorized attempts at access and reject them. Inside the firewall, the actual data is encrypted. However, stopping unauthorized access without placing onerous restrictions on authorized users is very difficult, and even then, it is impossible to ensure that the authorized users are strictly following procedures intended to establish a truly secure perimeter. Moreover, once in, intruders may pose a much more sophisticated threat than just data theft. Hackers may insert malicious code into enterprise systems that is difficult to detect and opens them for much more extensive future incursions. Juniper, one of the top vendors of network firewalls just revealed that it had discovered sophisticated and unauthorized code that had been inserted into its routers to open a backdoor for hackers into its many customers’ networks. Commercial security solutions backed up by overtaxed and underprepared enterprise IT staffs are not a strong defense for this sort of system integrity attack.

Exh 15: Cybersecurity Specialists

We think that security will become a major selling point for cloud-based SaaS applications and IaaS public cloud hosts. These organizations – in particular, AWS, Microsoft Azure and Google Compute Engine – have extremely sophisticated, highly secret, proprietary security solutions backed by the best computer science talent in the industry, and comprehensive understanding and control of their software infrastructure. Meanwhile, we believe that a few enterprise security winners will separate themselves and the broader pack will disappoint.

Enough with the Devices Already

The last eight years in TMT have been defined by the smartphone. Not only did the unprecedented success of the iPhone multiply Apple’s market capitalization by nearly a factor of 10 over the past decade, but it also established the context for the success and failure of many other businesses as well. On the Android side, Samsung led the challenge, while pre-iPhone leaders Nokia and Blackberry languished. Component makers like ARM and Avago flourished. Companies with successful apps – Facebook, Uber, Google, Amazon, etc. – leapt to the fore. Penetration of smartphones into the world grew dramatically, as the devices pushed toward ubiquity in developed nations and spread country by country like an invasive species.

And now we’re done. Or nearly so. The growth in the global installed base of mobile phones has slowed sharply from 15.9% in 2011 to 3.1% in 2015, with almost all of new subscriptions coming at the very low end of the market in developing economies (Exhibit 16). Within that, the base of premium smartphones (defined by Garner as exceeding certain thresholds in a basket of technical specs) has almost entirely flattened. Growth at the premium end has come from a strong rise in replacement demand from existing users, which has risen to an all-time high, at 37% of the installed base from 33.2% in 2011. Replacement phones now account for more than 93% of all phones sold, across tiers (Exhibit 17).

Exh 16: Global Mobile Phone Installed Base and Percent of New Phone Sales Contributing to Base Growth, 2010-20

Exh 17: SSR Handset Unit Sales Forecast , 2012-20

Against this backdrop, Apple has been a big success story, taking market share, raising its average price, and stimulating faster replacement. With the 5S/5C launch in the fall of 2013, Apple signed initial distribution agreements with China Mobile and NTT DoCoMo, allowing them to address hundreds of millions of previously unavailable subscribers. With the iPhone 6 launch in September 2014, Apple finally offered the large screens that had been available from its Android-based rivals for years. These products were wildly popular, pulling significant upgrade demand forward and establishing a substantially higher average price point for Apple. Pulling these levers has covered for the underlying stagnation in penetration, but we do not see further levers for Apple to pull.

Device bulls suggest that Apple’s move to promote a device leasing program with annual upgrades can take replacement activity even higher than the current all-time high levels, but we are very skeptical (Exhibit 18). First, significant uptake in such a program would shift the availability of used iPhones on the active secondary market, taking prices lower and cannibalizing some demand in the primary market. Second, similar plans have been available from US carriers, but have not proven particularly popular, as the monthly cash outlay is much higher than with increasingly popular lease to own programs that actually encourage subscribers to hold on to their older smartphones.

Exh 18: Global Phone Replacement Rates, 2011-20

Finally, we believe that many of the specs that formed the basis of smartphone differentiation over the past few years – screen size and resolution, processor speed, camera pixel density, app availability, etc. – have reached the point of seriously diminishing returns. The iPhone 6, as the first large screen Apple model, tapped reservoirs of latent demand and pulled significant upgrade demand forward. The new aspects of the 6S are not nearly so inspiring. Premium smartphone sales will decline in 2016, with the only growth in the whole mobile phone market coming from the very low end, where sub-$100 smartphones are crowding out similarly priced feature phones. For traditional phone brands, this shift has brought new competition from emerging market brands empowered by turnkey component and software solutions. In this context, we predict significant disappointment in 2016 for overall smartphone volumes, and for the established smartphone brands – Apple, Samsung, LG and HTC chief amongst them.

Meanwhile, the well-hyped wearables and Internet-of-Things (IoT) markets are nascent and slow to get traction. In particular, the Apple Watch, with its $500 average price point, offers too little real functionality at too high of an out of pocket cost to inspire significant demand beyond relatively price insensitive early adopters. We expect the early pace of sales to slow, with 2016 Holiday demand likely up very little from this past season. Nor do we see any other connected gadget as ready to make a breakout – “next year” is still a few years away.

OTAs Will Begin Their Descent

On-line Travel Agencies (OTA) have been one of the big digital business success stories, taking nearly 40% of the bookings in the $1.3T travel industry. The rest is booked through traditional channels – travel agencies, corporate travel offices, and direct with the service providers. However, while most internet business models disintermediate traditional middlemen, OTAs have thrived as a layer between travel service providers and on-line platforms, like iOS, Google Search, and others. The OTA field has been thinned through consolidation to three major consumer facing players, Priceline, Expedia and TripAdvisor, each with a market cap of better than $10B, and a backend distribution platform, Sabre, which aggregates pricing and inventory data for many industry players.

Prior to the rise of the OTAs, travel bookings were handled directly by the suppliers and through a fragmented network of licensed agents. The 1990’s brought the original travel booking sites – Microsoft’s Expedia, Sabre’s Travelocity, and Priceline – which gave consumers an ability to book and manage complex itineraries. These sites gained the upper hand over the individual sites of travel service suppliers – airlines, hotels and car rental agencies. In the aftermath of 9/11, travel activity declined precipitously, taking nearly three years for passenger traffic levels to recover and sending nearly every US airline into bankruptcy court. Suppliers saw the new OTAs as a compelling option to offload large amounts of unfilled inventory and cut deals for innovative products, e.g. Priceline’s opaque “Name Your Own Price” tool.

In travel, there is a delicate balance with managing supply and demand as unused inventory such as empty seat or unoccupied hotel room is considered “spoiled” and lost forever. However, airlines have become better at this than hotels and the past decade has seen airlines gain leverage in their OTA deals. Industry consolidation took the number of domestic legacy carriers down from 6 to 3. A challenging oil price environment forced airlines to rationalize routes and capacity and add ancillary charges like bag fees, legroom upgrades, etc. making them consistently profitable for the first time since the industry was deregulated in 1978. The result was domestic airline commissions paid to travel agents fell from 13% in the mid-1990s to just above 1% of revenue last year. Expedia saw its revenue mix from airlines decline from 22% in 2005 to 8% for the last 12 months ending in October 2015 (Exhibit 19). In this context, we believe airlines will continue to press their advantages against OTAs, holding superior prices and more flexible policies for tickets booked directly on their own sites and apps.

Hotels typically have less leverage than airlines, with rigorous competition in most markets and many points of differentiation from property to property. The OTA platforms facilitate research for travelers, adding significant convenience for customers that follow on to book directly on the platform. As a result, OTA commissions for hotels are typically in the 20-25% range and make up a significant portion of OTA revenue and profits. This has not gone unnoticed by hotel management companies like Marriott, Starwood, and Hilton, which continue to cite OTA activities as a business risk. Like the airlines, we expect the hotel companies to become more aggressive when it comes to negotiating commissions, and to seek alternative platforms for marketing their properties to travelers.

Exh 19: Expedia Sources of Revenue, 2005 vs. 2015

An obvious alternative are travel research tools offered directly by mobile platforms, such as Google, Amazon or Apple. Google search features hotel summaries and reviews, and also points users to hotel providers and third party booking sites via sponsored ads also taking a cut. AMZN may have shuttered its hotel oriented Destinations product, but OTA margins look too high for Jeff Bezos not to take another swing. We would not be surprised to see Apple integrate travel booking capabilities into its iOS Passbook app. Finally, the growing popularity of alternative accommodation services, like AirBnB, and dozens of other small niche players like HomeEscape, KidandCoe, and PreferredResidences could be significant competition. It is in these contexts that we predict revenue deceleration and tighter margins across the OTA market.

We’re Going Back… to the Future

This year’s CES may as well have been “The Las Vegas Auto Show”, what with all the electric, connected and self-driving vehicles that spilled out of the North Hall into the outdoor exhibit area. While the surface glitz promoted a vision of Detroit and Silicon Valley in partnership, the heavy subtext was of wary mistrust between the culturally mismatched stakeholders in the future of the multi-trillion dollar transportation industry. We wrote a piece detailing our perspective on automotive and tech back in October (http://www.ssrllc.com/publication/car-tech-silicon-valley-takes-on-detroit/). However, despite numerous product launches and partnerships, we don’t expect meaningful revenue or profit growth from EV and autonomous vehicles to happen yet in 2016. A low oil price environment combined with a record year for auto sales in 2015 doesn’t help the case for EVs. Autonomous Vehicles are being prototyped, but nowhere near ready for go to market given some remaining technical hurdles and their street legality is in limbo in most states.

Progress on EVs has been slow and steady – battery tech follows a linear improvement trajectory, and issues with industry standards and service infrastructure require cooperative solutions – making this more of a sustaining innovation rather than a disruptive one within the Christensen framework. Tesla, 13 years in and a pioneer in most aspects of EV design, still finds itself generally unprofitable with 2015 unit sales of just 50K cars and faces enlightened incumbents, like BMW, which can lever the scale and experience behind its 2 million annual unit sales toward its fledgling EV business and its 17.8K cars sold. Indeed, Tesla’s endgame may be as a dominant vendor of batteries – it has contributed all of its IP toward open standards and committed billions of dollars toward building its Gigafactory manufacturing plant in Nevada. Batteries produced there, and at future Gigafactories by TSLA’s plans, are meant not just for Tesla cars but for all standards compliant EVs, as well as for residential and industrial applications. Tesla also previewed its PowerWall home batteries last year, meant to work in concert with solar systems and ween consumers off the grid.

Apple’s EV development and its 1,800 employee skunk works operation is one of Silicon Valley’s worst kept secrets, but one which Tesla CEO Elon Musk welcomes to “expand the industry.” Apple’s track record is too good to count them out, and its device electronics and systems software expertise are surely powerful and unique assets. Still, it is also far down the experience and scale curves on many of the elements of auto design and manufacturing, with an ambitious rumored target date of 2019. Just as much rumored the Apple TV set turned out to be something less audacious than first envisioned, we see a partnership with a like-minded incumbent like BMW or Mercedes to be much more likely than an Apple car built from the ground up.

Incumbent automakers have been busy and EV sales are currently concentrated around a handful of players. Nissan’s LEAF, Chevy’s Volt, and BMW’s i3 make up 37% of EV sales, while Tesla has 23% share. The remaining 40% are a motley crew of offerings from Ford, Fiat, VW and Toyota along with high end offerings from GM and BMW (Exhibit 20). The BMW i8 and Porsche’s EV offerings represent the high end with sticker prices in the six figures and will never be mass market. EVs have been a hobby for Toyota, which paused production on its Prius plugin, as it continues to focus on hybrid offerings and invest in hydrogen fuel cell vehicles. VW, embroiled in its emissions scandal could turn to boosting EV output as a mea culpa, but none of its offerings really addresses the mass market. Of this group, GM appears the most serious in launching a mass market EV. The Chevy “Bolt,” unveiled at this week’s Detroit Auto Show will be priced at $30K with a 200 mile range competitive with more expensive offerings from Tesla.

However, for all of the headlines, we believe that the market impact of EVs in 2016 will be disappointing. The recent implosion of oil prices to decade lows driven by macro and geopolitical pressures (Saudi oil output expansion, economic turmoil in China, and US Dollar Strength) could stall demand for EVs as the economics of fossil fuels become attractive again. While automakers sold a record 17.5M cars in the US in 2015, only 116K were plugin EVs, down -5% from 2014 despite Tesla’s sales and production growth. So far in 2016, nothing really appears to have changed.

Exh 20: US Electric Vehicle Sales, 2011-15

Like EVs, most incumbent car makers are also investing in self-driving tech, intending it as an auto-pilot option for otherwise traditionally operated vehicles. Alphabet’s plans are more expansive, looking to challenge Uber for the future of local transportation with fleets of autonomous vehicles, leveraging years and millions of miles of driving data processed by the company’s world leading deep learning and data analytics capabilities. Amazon and Ford just announced a partnership at CES that will bring Echo technology into cars and include collaboration on self-driving vehicles. Uber has its own skin in this game, having recently funded a substantial research initiative into self-driving vehicles with Carnegie Mellon University. Still, the obstacles to commercialization remain considerable – Alphabet is far out in front in its 100% self-driving AI, but still hasn’t tested the product for true city driving or harsh weather conditions, and regulatory hurdles and public caution will take time to surmount. We believe that 2016 will be another quiet year for autonomous vehicle commercialization – expect a few more auto-parking or highway autopilot cruise control features on otherwise driver operated vehicles. Longer term, we believe that all of the contenders are chasing Alphabet, which, if anything, has been extending its lead.

Bigger is Better

In 2015, CNBC personality Jim Cramer coined the term FANG – an acronym of Facebook, Amazon, Netflix and Google – to highlight the stocks that were driving the market higher. Amazon and Netflix both doubled over the year, while Facebook and Google straggled to 31% and 42% appreciation respectively. After all of that, investors are surely tempted to take their profits and move on. We think that could prove costly.

Cloud-based businesses threaten multi-trillion dollar swaths of the economy – retail, advertising, wholesale, data center IT spending, transportation – with lower cost and more capable alternatives. These businesses, with inherent high fixed cost, low marginal cost natures, reward scale. The extraordinary technical sophistication of cloud computing and distribution platforms rewards experience and requires top-notch talent. All of this is to the great advantage of the FANGs (and to Microsoft), which are all outgrowing their smaller, would-be rivals.

Exh 21: U.S. e-Commerce quarterly sales and share of all retail, Q1 2000- Q4 2015

Exh 22: Retailer e-Commerce GMVs, 2014 and 2015

In e-commerce, Amazon transacts more than 35% of all US online sales, and is growing its Gross Merchandise Volume at nearly 25% (Exhibit 21-22). In streaming media, Netflix and Google’s YouTube together serve more than 50% of all online video traffic (Exhibit 23). In advertising, Google and Facebook capture more than half of mobile digital ad revenues – Twitter comes in third at about 4%, but is outgrowing the market by a factor of three (Exhibit 24). In IaaS web hosting Amazon and Microsoft have almost half the market and are furiously taking market share with 80% and 100% growth, respectively. These companies are not regressing to the mean, but cementing dominance that we believe will carry forth indefinitely.

Exh 23: Downstream Fixed Access Peak Web Traffic, 1H13 – 1H15

Moreover, these companies are finding new places to lever their core assets and skillsets. Amazon is leveraging its logistical mastery and infrastructure to attack the highly fragmented $24T global B2B wholesale market. Google plans to unleash its AI-powered autonomous vehicle initiative on the $6T personal transportation and delivery segment. Facebook sees plenty of opportunity in adding commerce to its social networking platforms. After expanding to another 115 countries, Netflix could move into ad supported services, live events, pay-per-view and other content monetization options. Microsoft is well positioned to lever its enterprise cloud leadership into differentiated SaaS applications, infrastructure software and tools, and consulting services.

We believe that growing dominance in huge and increasingly lucrative opportunities will allow these big companies to grow faster and gain more bottom line leverage than investors expect, and deliver better than market stock performance for 2016 and beyond.

Exh 24: Mobile Advertising Share, 2014-17

Who Will Buy?

2015 was a bit of a dud year for M&A in TMT. There was some consolidation in the chip space, as Avago snapped up Broadcom, and Intel agreed to buy Altera, but the biggest players remained relatively quiet. We expect the pace to pick up a bit in 2016, although we still don’t expect anyone to step up to buy Time Warner.

Alphabet has its hands tied a bit, as European scrutiny of its market power and business practices continues. If not for the EU, we believe CEO Larry Page would have already pounced on Twitter and/or Ebay, two companies with substantial potential synergies with core Google. We believe a negotiated resolution to the European investigation is more likely than not, and if so, we would expect Alphabet to step up. Otherwise, we expect them to be active in adding to their core Deep Learning AI and robotics strengths, and could add synergistically to their Nest home connectivity portfolio.

Facebook spent 2015 digesting its 2014 deals for WhatsApp and Oculus, but looks prepared to shop again in 2016. A news aggregation app, like the Twitter-linked Nuzzel or FlipBoard, would add another island in the Facebook-Instagram-Messenger-WhatsApp archipelago. Pinterest, with its natural native format for shopping, would be another interesting and highly synergistic acquisition.

Microsoft flirted with a Salesforce.com acquisition in 2015. We wouldn’t be surprised to see the companies quietly continue discussions in 2016, and for Satya Nadella to shop for strong, best-of-breed SaaS application companies to lever his enterprise position and powerful Azure infrastructure. Our model portfolio selection Tableau, with powerful, cloud-based data analytics tools, would be an excellent addition to Microsoft Office 365.

In the wake of the 2015 agreement between Dell and EMC, we also expect enterprise data center vendors to seek scale through consolidation and growth through acquisition. Hewlett Packard Enterprise, Cisco, Oracle, IBM, and SAP have not been shy about deals in the past and should be increasingly desperate, as the cloud-era seems to be passing them by.

Exh 25: Relative Coverage Advantages of Lower Frequency Spectrum versus Higher Frequencies

Going Once, Going Twice… SOLD

Initially recommended in the 2010 National Broadband Plan and authorized by Congress in 2012, the FCC’s incentive auction of 600 MHz TV spectrum is a first of its kind auction that will be comprised of two components: a “reverse auction” where holders of broadcast spectrum (UHF frequencies) will have the opportunity to reap a windfall on relinquishing their spectrum rights to bidders and a “forward auction” where the FCC will award new 600-band flexible use licenses. The 600 MHz band is unusually attractive because it has a significantly greater range than the spectrum ranges currently in use for cellular wireless and penetrates easily through obstructions like buildings and walls (Exhibit 25). This makes services using the band cheaper to deploy, with fewer towers needed, inherently better coverage and more reliable signal availability. As such, we expect carriers and other interested parties to bid aggressively for this beachfront property.

The FCC released eye-popping opening prices for the reverse auction that start the “go off the air” licenses for New York City alone at $17.5B, while secondary markets like Hartford/New Haven are worth $4B at the open (Exhibit 26). Actual prices will be lower as prices come down with each round, but the enthusiasm of potential buyers should keep the total proceeds high. The potential for this windfall set off a buying frenzy of small TV stations around the country over the past couple of years by private equity firms, though major station owners like Sinclair Broadcasting, Nexstar, and Media General have seen their stocks trade off their highs despite the prospect of cash windfalls. The National Association of Broadcasters expects participation from stations to be robust and most station groups have indicated they will participate. While we are firm believers in the unravelling of channelized TV, broadcast owners could be good buys going into the process as auction windfalls could spur capital return programs.

Exh 26: FCC 600MHz Incentive Auction Starting Prices, Top 10 DMAs

The auction will be the most complex ever undertaken by the FCC and we expect it will take more than 6 months, attract more than 90MHz of spectrum, and generate more than $60B in spending. Though Sprint has publicly bowed out of bidding, we expect Verizon, AT&T and T-Mobile will spend big, with T-Mobile leveraging itself to buy the biggest chunk. T/VZ will also make some big purchases, mostly in major metro areas to shore up their networks. Dish’s Charlie Ergen who was forced to cede some spectrum and pay a fine last year, hasn’t ruled out bidding in the incentive auction and could be a wildcard. We expect at least 1 consortium of non-traditional bidders to win spectrum, with Alphabet, and Comcast expected to participate, although not necessarily together.

The Picks

We revealed our top picks for the first half of 2016 last week, choosing Alphabet, Microsoft, and Twitter as longs, and Oracle, Juniper, and Interpublic Group as shorts. The rationale can be seen here (http://www.ssrllc.com/publication/tmt-the-longs-and-shorts-of-it/). The first two weeks of January have been hard on our selections, particularly Twitter (down almost 28% YTD), but we believe that the underlying investment cases remain sound, and that the concerns dogging the overall market (China, oil, industrial output, FX) have relatively little effect on most of the stocks in our model portfolio. With all six stocks, we expect appropriate catalysts to play out over the next few months. We anticipate revisiting the selections at mid-year.

The 2015 Score Card

Our self-graded score card for 2015 shows two A+s, two As, a B+, a B, two B-s, and two Cs, for a fairly solid 3.37 GPA. The rationale is given in the exhibit (Exhibit 27). We hope to do better this year, particularly with the performance of the top picks.

Exh 27: SSR 2015 Prediction Scorecard

©2016, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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