TMT: Paradigm Shift! Which Side are You On?

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SEE LAST PAGE OF THIS REPORT Paul Sagawa / Artur Pylak

FOR IMPORTANT DISCLOSURES 203.901.1633 /.1634

sagawa@ / pylak@ssrllc.com

twitter.jpg @SecSovTMT

June 12, 2012

TMT: Paradigm Shift! Which Side are You On?

  • The TMT sector is in the midst of a comprehensive once-in-a-generation paradigm shift driven by the contemporaneous maturation of several key innovations that offer consumers and businesses new and significantly better ways to use information. In this, we expect the few platforms that control user experiences (AAPL, GOOG, MSFT, maybe AMZN) will capture a disproportionate share of value, with portable device components, content creators, advertizing facilitators and differentiated web-based businesses also likely to benefit. Distribution networks – e.g. wireless operators, telcos, cable MSOs, CDNs, etc. – and their suppliers, may or may not benefit depending on competition and regulation. On the enterprise side, we see cloud services steadily gaining vs. enterprise data center spending, commoditizing hardware and pressuring traditional software in the process. Companies dependent on the staples of the older paradigm – e.g. PCs, Cable TV, private data centers, etc. – will likely suffer. We have built large cap and small cap model portfolios representative of the companies that we expect to prosper in the new paradigm. Thus far, the relative performance of these model portfolios has been strong, although they have underperformed during the past three months.
  • TMT is in the midst of a tectonic plate shift, akin to the ‘80’s, which saw the rise of a new order of leaders and the death of many old paradigm players. The ‘80’s saw the first PCs, the first cell phones, the break-up of AT&T, the Cable Act of 1984 (which dropped the limit on out of market signals for MSOs), and the rise of Ethernet, setting the stage for all of the TMT developments of the past three decades, including the Internet, and sounding the death knell for the minicomputer era. Today, the simultaneous maturation of portable devices, integrated user interface platforms, fast wireless networks, CDNs, and cloud applications is driving a similarly dramatic, self-reinforcing and irreversible transformation.
  • A disproportionate share of the value generated by the consumer Internet will accrue to portable platform owners – i.e. Apple, Google, Microsoft, and perhaps, Amazon. The Internet continues to absorb value from the rest of the economy, with an addressable market of trillions of dollars. In contrast to the PC era, where browsers offered a neutral vehicle to web-based resources, portable platform apps, tightly controlled by platform owners, are becoming the predominant way for consumers to use information. This gives Apple, Google, Microsoft, and maybe, Amazon, enormous advantage in pursuing new Internet-based opportunity.
  • With the rise of portable platforms and cloud-based services, device components, content owners, ad agencies, and well-positioned web services will benefit. Businesses that operate in service of the portable platforms will also have opportunity to take advantage, particularly if they have competitive barriers to protect against vertical integration by the platform owners. We see device component providers (hardware and software), owners of unique content, advertising specialists, and well differentiated web services with critical mass as attractive areas.
  • Distribution networks – e.g telcos, cable, etc. – have colluded to set speed bumps, but will likely face competition, regulation or both, raising opportunity for their suppliers. The emerging TMT paradigm is driving huge traffic growth, taxing both wireless and wired networks. Operators have responded with price hikes, usage tiers and throttling rather than capex, the product of tacit collusion, hobbled competition and lax regulation. As a result, leading network owners have seen unusual returns on investment. History suggests that such returns are unstable, as innovation, rivalry and/or regulation could spur investment and price aggression at any time. Moreover, we would not discount the potential of wireless to compete effectively for residential broadband or the possibility of investment from cash rich internet platform players to help to make it so. In this case, communications equipment vendors, tower companies, web platform players and consumers would be the biggest beneficiaries.
  • Enterprise cloud services will gain steadily, benefiting hosts, SaaS, and consultants while crowding out private data center builds and commoditizing traditional IT. After years of investment, the virtualization of enterprise data centers has peaked and surveys suggest that shifting appropriate applications to the cloud is the new top CIO priority. As this trend gains momentum, it will benefit scale-efficient hosting businesses, software-as-a-service application vendors, IT consultants, and commodity components. IT investment will shift away from private data centers toward sophisticated web hosts, sapping demand for the high margin, value added solutions offered by traditional IT vendors.
  • We expect demand for old paradigm products and services – e.g. PCs, Cable TV, high end data center hardware, traditional enterprise software, etc. – to crest and wane. The new TMT paradigm, based on portable devices, integrated app-focused platforms, distributed public data centers and cloud-optimized applications, will render many stalwart products and services from the past few decades inert. The changing of the guard will play out over years rather than weeks, but we see the decline of x86 PC architecture, channelized television, integrated enterprise hardware solutions (servers, storage, networking, etc.), closed architecture infrastructure software, and other old paradigm architectures as inevitable.
  • Our model portfolio constituents are well positioned for these opportunities, relatively insulated against threats, and have demonstrated an ability to generate cash flow. We maintain a large cap and a small cap model portfolio composed of representative stocks well placed for the paradigm shift, and screened for cash flow returns and growth. Performance of these stocks has been strong over the life of the portfolio, but poor for the past three months. We are adding WPP and N to our large cap portfolio, replacing RVBD and OPEN, which moves to the small cap portfolio. The small cap portfolio sees N graduate to the large cap, replaced by OPEN. We are also removing UBNT, TTWO and UEIC and adding DDD, MKTG, and ENTG

Note

This piece is intended as a summary of our thesis of overarching paradigm change in the TMT sector that we have explored in detail, part by part, in our previous research. While we believe that each of the themes addressed in our more focused research stands on its own merits, we also see them as mutually reinforcing, driving faster and more complete change than might be expected in isolation. As we touch on these underlying themes in this note, we will include links to relevant research pieces with more detail on each topic.

From 40,000 Feet

For the past two years or so, we have been publishing model portfolios of stocks representative of our view of the changing TMT landscape. Candidates for the large cap and small cap portfolios are first screened based on our assessment of their positioning vs. growth opportunities and their exposure to business areas that we deem at risk. We then further screen companies based on cash flow yields and sales growth, two metrics that have shown some efficacy as predictors of future performance. The resulting portfolios, 15 large cap stocks and 25 small cap stocks are spread across nine growth categories – Portable Device Technology, Platforms, Wireless Broadband, Content, Advertising, Differentiated Cloud Services, Cloud Hosts/Consultants, Commodity Hardware, and Software-as-a-Service – and are intended to be illustrative of the types of companies that could be expected to benefit from the trends that we believe are shaping the future of technology, media and telecommunications (Exhibits 1-2).

Exh 1: SSR Large Cap TMT Model Portfolio Performance Original Constituents Before Q2 Revision

The changes that we see are both profound and comprehensive. Over the decades, the intertwined worlds of technology, media and telecommunications have been periodically reborn, phoenix-like, with old paradigms fading and new ones moving to the fore. The last such transformation played out in the 1980’s, when the near simultaneous introduction of PCs and cell phones coincided with the break-up of the Bell System and the passage of the Cable Act of 1984, which loosed the Cable industry to deliver out-of-region stations. The fallout saw the majority of computer industry leaders fail and a corresponding roster of future market leaders begin their rise. Microsoft, Intel, Dell, Cisco, EMC, Oracle, and Comcast all made their bones in this era, with IBM, HP, Verizon and AT&T the primary survivors from the previous age.

Exh 2: SSR Small Cap TMT Model Portfolio Performance Original Constituents Before Q2 Revision

The current tectonic plate shift also proceeds from a concert of significant innovations. The meteoric rise of smartphones and tablets has been exhaustively examined, but remains no less disruptive for the hype (Exhibits 3-4). With these portable platforms came a new interface paradigm that explicitly tied device functionality to the internet, opened the integration of applications across devices, and gave platform owners tight control over apps, and thus, web-based services accessed via devices. The groundbreaking functionality of these devices would not be possible without a simultaneous spread of ever faster wireless networks, or without the deployment of content delivery networks that put distributed data center sites physically close to users, dramatically improving performance and availability in the process. All of this in turn has contributed to the rise of cloud-based consumer applications that leverage the seemingly unlimited processing and storage resources in the Internet. These changes are playing out more quickly than almost anyone had predicted, with the new paradigm at the verge of becoming the predominant way that consumers use information.

The changes in the enterprise IT market will be slower to develop, but will be no less profound. The investment in virtualization technology for enterprise data centers over the past several years enables organizations to make better use of portable platforms, which have already begun to spring up in focused applications or as part of “Bring Your Own Device” policies. The virtualized internal data center investment is itself, a precursor to moving a meaningful portion of enterprise applications to external cloud-based hosts, and eventually, transitioning to shared Software-as-a-Services applications. The upshot of this transition is obviously positive for the web-hosts, SaaS vendors and IT consultants that will make it happen, but will also lead to the commoditization of swaths of traditional IT.

Exh 3: US Smartphone Users

Exh 4: Global Media Tablet Shipment Forecast, Worldwide, 2010-2015

The nine growth categories mentioned at the top of the page are the most likely beneficiaries of this sea change, with the device platform owners (Apple, Google, Microsoft and maybe, Amazon) in position to co-opt the largest share of value created by the new paradigm (Exhibit 5). At the same time, we see several TMT sub-sectors as at particular risk – i.e. x86 PC architecture, channelized video distributors (cable, satellite, etc.), web businesses without sufficient barriers to competition, value-added IT hardware, infrastructure software, and traditional enterprise applications. The extraordinary rise of mobile platforms over the past few years – note that 70 million iPads have sold in the first two years of its existence – suggests that the paradigm shift may be playing out far faster than even the most aggressive forecasts had suggested and that the threats to the at-risk subsectors may be closer on that defenders wish to acknowledge.

Exh 5: Relative Performance Summary of Large Cap Tech Stocks by Category

SEE LAST PAGE OF THIS REPORT Paul Sagawa / Artur Pylak

FOR IMPORTANT DISCLOSURES 203.901.1633 /.1634

sagawa@ / pylak@ssrllc.com

twitter.jpg @SecSovTMT

June 12, 2012

TMT: Paradigm Shift! Which Side are You On?

  • The TMT sector is in the midst of a comprehensive once-in-a-generation paradigm shift driven by the contemporaneous maturation of several key innovations that offer consumers and businesses new and significantly better ways to use information. In this, we expect the few platforms that control user experiences (AAPL, GOOG, MSFT, maybe AMZN) will capture a disproportionate share of value, with portable device components, content creators, advertizing facilitators and differentiated web-based businesses also likely to benefit. Distribution networks – e.g. wireless operators, telcos, cable MSOs, CDNs, etc. – and their suppliers, may or may not benefit depending on competition and regulation. On the enterprise side, we see cloud services steadily gaining vs. enterprise data center spending, commoditizing hardware and pressuring traditional software in the process. Companies dependent on the staples of the older paradigm – e.g. PCs, Cable TV, private data centers, etc. – will likely suffer. We have built large cap and small cap model portfolios representative of the companies that we expect to prosper in the new paradigm. Thus far, the relative performance of these model portfolios has been strong, although they have underperformed during the past three months.
  • TMT is in the midst of a tectonic plate shift, akin to the ‘80’s, which saw the rise of a new order of leaders and the death of many old paradigm players. The ‘80’s saw the first PCs, the first cell phones, the break-up of AT&T, the Cable Act of 1984 (which dropped the limit on out of market signals for MSOs), and the rise of Ethernet, setting the stage for all of the TMT developments of the past three decades, including the Internet, and sounding the death knell for the minicomputer era. Today, the simultaneous maturation of portable devices, integrated user interface platforms, fast wireless networks, CDNs, and cloud applications is driving a similarly dramatic, self-reinforcing and irreversible transformation.
  • A disproportionate share of the value generated by the consumer Internet will accrue to portable platform owners – i.e. Apple, Google, Microsoft, and perhaps, Amazon. The Internet continues to absorb value from the rest of the economy, with an addressable market of trillions of dollars. In contrast to the PC era, where browsers offered a neutral vehicle to web-based resources, portable platform apps, tightly controlled by platform owners, are becoming the predominant way for consumers to use information. This gives Apple, Google, Microsoft, and maybe, Amazon, enormous advantage in pursuing new Internet-based opportunity.
  • With the rise of portable platforms and cloud-based services, device components, content owners, ad agencies, and well-positioned web services will benefit. Businesses that operate in service of the portable platforms will also have opportunity to take advantage, particularly if they have competitive barriers to protect against vertical integration by the platform owners. We see device component providers (hardware and software), owners of unique content, advertising specialists, and well differentiated web services with critical mass as attractive areas.
  • Distribution networks – e.g telcos, cable, etc. – have colluded to set speed bumps, but will likely face competition, regulation or both, raising opportunity for their suppliers. The emerging TMT paradigm is driving huge traffic growth, taxing both wireless and wired networks. Operators have responded with price hikes, usage tiers and throttling rather than capex, the product of tacit collusion, hobbled competition and lax regulation. As a result, leading network owners have seen unusual returns on investment. History suggests that such returns are unstable, as innovation, rivalry and/or regulation could spur investment and price aggression at any time. Moreover, we would not discount the potential of wireless to compete effectively for residential broadband or the possibility of investment from cash rich internet platform players to help to make it so. In this case, communications equipment vendors, tower companies, web platform players and consumers would be the biggest beneficiaries.
  • Enterprise cloud services will gain steadily, benefiting hosts, SaaS, and consultants while crowding out private data center builds and commoditizing traditional IT. After years of investment, the virtualization of enterprise data centers has peaked and surveys suggest that shifting appropriate applications to the cloud is the new top CIO priority. As this trend gains momentum, it will benefit scale-efficient hosting businesses, software-as-a-service application vendors, IT consultants, and commodity components. IT investment will shift away from private data centers toward sophisticated web hosts, sapping demand for the high margin, value added solutions offered by traditional IT vendors.
  • We expect demand for old paradigm products and services – e.g. PCs, Cable TV, high end data center hardware, traditional enterprise software, etc. – to crest and wane. The new TMT paradigm, based on portable devices, integrated app-focused platforms, distributed public data centers and cloud-optimized applications, will render many stalwart products and services from the past few decades inert. The changing of the guard will play out over years rather than weeks, but we see the decline of x86 PC architecture, channelized television, integrated enterprise hardware solutions (servers, storage, networking, etc.), closed architecture infrastructure software, and other old paradigm architectures as inevitable.
  • Our model portfolio constituents are well positioned for these opportunities, relatively insulated against threats, and have demonstrated an ability to generate cash flow. We maintain a large cap and a small cap model portfolio composed of representative stocks well placed for the paradigm shift, and screened for cash flow returns and growth. Performance of these stocks has been strong over the life of the portfolio, but poor for the past three months. We are adding WPP and N to our large cap portfolio, replacing RVBD and OPEN, which moves to the small cap portfolio. The small cap portfolio sees N graduate to the large cap, replaced by OPEN. We are also removing UBNT, TTWO and UEIC and adding DDD, MKTG, and ENTG

Note

This piece is intended as a summary of our thesis of overarching paradigm change in the TMT sector that we have explored in detail, part by part, in our previous research. While we believe that each of the themes addressed in our more focused research stands on its own merits, we also see them as mutually reinforcing, driving faster and more complete change than might be expected in isolation. As we touch on these underlying themes in this note, we will include links to relevant research pieces with more detail on each topic.

From 40,000 Feet

For the past two years or so, we have been publishing model portfolios of stocks representative of our view of the changing TMT landscape. Candidates for the large cap and small cap portfolios are first screened based on our assessment of their positioning vs. growth opportunities and their exposure to business areas that we deem at risk. We then further screen companies based on cash flow yields and sales growth, two metrics that have shown some efficacy as predictors of future performance. The resulting portfolios, 15 large cap stocks and 25 small cap stocks are spread across nine growth categories – Portable Device Technology, Platforms, Wireless Broadband, Content, Advertising, Differentiated Cloud Services, Cloud Hosts/Consultants, Commodity Hardware, and Software-as-a-Service – and are intended to be illustrative of the types of companies that could be expected to benefit from the trends that we believe are shaping the future of technology, media and telecommunications (Exhibits 1-2).

Exh 1: SSR Large Cap TMT Model Portfolio Performance Original Constituents Before Q2 Revision

The changes that we see are both profound and comprehensive. Over the decades, the intertwined worlds of technology, media and telecommunications have been periodically reborn, phoenix-like, with old paradigms fading and new ones moving to the fore. The last such transformation played out in the 1980’s, when the near simultaneous introduction of PCs and cell phones coincided with the break-up of the Bell System and the passage of the Cable Act of 1984, which loosed the Cable industry to deliver out-of-region stations. The fallout saw the majority of computer industry leaders fail and a corresponding roster of future market leaders begin their rise. Microsoft, Intel, Dell, Cisco, EMC, Oracle, and Comcast all made their bones in this era, with IBM, HP, Verizon and AT&T the primary survivors from the previous age.

Exh 2: SSR Small Cap TMT Model Portfolio Performance Original Constituents Before Q2 Revision

The current tectonic plate shift also proceeds from a concert of significant innovations. The meteoric rise of smartphones and tablets has been exhaustively examined, but remains no less disruptive for the hype (Exhibits 3-4). With these portable platforms came a new interface paradigm that explicitly tied device functionality to the internet, opened the integration of applications across devices, and gave platform owners tight control over apps, and thus, web-based services accessed via devices. The groundbreaking functionality of these devices would not be possible without a simultaneous spread of ever faster wireless networks, or without the deployment of content delivery networks that put distributed data center sites physically close to users, dramatically improving performance and availability in the process. All of this in turn has contributed to the rise of cloud-based consumer applications that leverage the seemingly unlimited processing and storage resources in the Internet. These changes are playing out more quickly than almost anyone had predicted, with the new paradigm at the verge of becoming the predominant way that consumers use information.

The changes in the enterprise IT market will be slower to develop, but will be no less profound. The investment in virtualization technology for enterprise data centers over the past several years enables organizations to make better use of portable platforms, which have already begun to spring up in focused applications or as part of “Bring Your Own Device” policies. The virtualized internal data center investment is itself, a precursor to moving a meaningful portion of enterprise applications to external cloud-based hosts, and eventually, transitioning to shared Software-as-a-Services applications. The upshot of this transition is obviously positive for the web-hosts, SaaS vendors and IT consultants that will make it happen, but will also lead to the commoditization of swaths of traditional IT.

Exh 3: US Smartphone Users

Exh 4: Global Media Tablet Shipment Forecast, Worldwide, 2010-2015

The nine growth categories mentioned at the top of the page are the most likely beneficiaries of this sea change, with the device platform owners (Apple, Google, Microsoft and maybe, Amazon) in position to co-opt the largest share of value created by the new paradigm (Exhibit 5). At the same time, we see several TMT sub-sectors as at particular risk – i.e. x86 PC architecture, channelized video distributors (cable, satellite, etc.), web businesses without sufficient barriers to competition, value-added IT hardware, infrastructure software, and traditional enterprise applications. The extraordinary rise of mobile platforms over the past few years – note that 70 million iPads have sold in the first two years of its existence – suggests that the paradigm shift may be playing out far faster than even the most aggressive forecasts had suggested and that the threats to the at-risk subsectors may be closer on that defenders wish to acknowledge.

Exh 5: Relative Performance Summary of Large Cap Tech Stocks by Category

The Rise of Planet of the Apps

The launch of the iPhone in 2007, followed by the introduction of Android less than a year later, finally unleashed the power of the Internet on mobile devices. Prior to the iPhone, wireless carriers worldwide carried out a program of suppression, pushing AOL-esque walled gardens of approved (and paid) content to their captive subscribers. Apple, taking advantage of the spread of faster 3G networks and the enormous popularity of its iPod music products, cut exclusivity deals with the more aggressive carriers, walking away with unlimited data plans for its users and extraordinary subsidies for itself. Nearly 150 million iPhones, and more than 250 million Android devices later, carriers are having a very difficult time shoving the genie back into the bottle, as smartphones with unfettered Internet access have laid feature phones with their heavily carrier proscribed interfaces and curated web experiences obsolete (Exhibit 6).

Tablets are no less a phenomenon. With 70 million iPad shipments in just 2 years of availability, Apple’s category defining innovation is on a steeper adoption trajectory than the iPhone. Google, caught more flatfooted by tablets than smartphones, did not deliver its tablet-optimized Honeycomb Android release until more than a year afterward, but appears to be gaining traction after its initial missteps. Amazon built its own interface on top of Android and made a 2011 Christmas splash with its low priced Kindle Fire tablet, although sharply slower sales post-Holiday have market observers curious about the e-tailer’s next move.

Exh 6: Smartphone Operating System Share

Microsoft, which has struggled for years with its smartphone efforts, appears to finally be on the right track. Both the Windows and Windows Phone operating systems have been revamped to suit the mobile device paradigm, featuring a slick new tile-based user interface codenamed “Metro”. The smartphone program starts from far back in the pack, but has strong support from carriers, equipment makers, enterprises, and software publishers, all of whom are anxious to see a viable third alternative to Apple and Google. Windows Phone may also get a boost from the 4Q12 launch of Windows 8, which breaks free of the Intel x86 dependence to support the ARM processor architecture favored by mobile platform makers and extends Microsoft’s desktop flagship OS all the way to touch screen tablets. Supporting legacy Windows applications, we believe Windows 8 will entice formerly reticent enterprise IT managers to consider portable platforms as alternatives to more bulky and expensive PCs, with Windows Phone, based on the same interface and able to support some of the same software, an interesting adjunct.

We covered the theme of mobile device and apps last month in our May 15, 2012 piece: “The Internet Revolution: It’s Not Social OR Mobile, It’s Apps”

Bedtime for Browsers

The portable device platforms – Apple’s iOS, Google’s Android, Microsoft’s Windows Phone/Windows8, and Amazon’s Fire – are distinct from the traditional PC platform in several important dimensions. First, they are designed to be thin. They require less processor heft, less memory, and thus, less power in portable devices where real estate and battery life are precious commodities. Second, they are designed to work with the cloud. Apps blur the distinction between local and cloud for both processing and storage. Third, they are designed to work with touch screens. The vocabulary of gestures is intuitive without requiring cumbersome adjunct input mechanisms like pens, mice or keyboards, particularly critical for devices meant to be used away from a desk. Fourth, they support processors from a wide array of suppliers, spurring both innovation and price competition. Fifth, they are competitive with one another – again spurring innovation and price competition.

Exh 7: Top Smartphone Properties and User Engagement (Browser versus App)

Finally, and most importantly, they are designed to work with Apps. Apps provide a customized shortcut to web services, offering a convenient way to involve device hardware in process. Consumer preference for using apps for access is overwhelming – for major apps like Facebook, Twitter and Amazon, more than 80% of mobile usage comes via apps vs. the browser (Exhibit 7). However, while apps allow web service providers opportunity to customize interfaces and to post their brand right on the launch screen, there is a real downside. The platform owner – i.e. Apple, Google, and Microsoft – holds most of the cards. If an app is particularly valuable or useful, the platform owner may integrate similar functionality right into the operating system, as Apple is doing with mapping and as Google has done with its search, maps, places, docs, drive, play and Google+ social networking product. If they don’t have the ability to go in house, the platform owner may strike a deal to make a favored partner a default app that ships pre-loaded in prime real estate – usually for a substantial fee – thus crowding out would-be competitors, as few users ever change out their defaults. Furthermore, the app stores themselves are run by the platform owners, which can feature favored apps and, at least in the case of Apple, extract a substantial percentage of the revenue associated with the app merely for the privilege of allowing the app in the store.

Contrast this with the PC paradigm. Microsoft was forced to separate its internet browser from its operating system as the key provision of its antitrust settlement with the US DoJ. This prohibited Microsoft from taking an aggressive stance to favor its own web services during the rise of the Internet, and established the browser as a largely neutral window. Arguably, Internet pillars, such as Google Search, Apple’s iTunes, Amazon e-commerce, or Facebook, could have been thwarted if Microsoft had exercised as much control over PC users as Apple wields over its customers.

Meanwhile, the rapid expansion of the internet economy continues apace, with trillions of dollars of retail, advertising, media, transaction services, and consumer services addressable by web based businesses. With portable platforms on a trajectory to be the predominant way that American consumers access the web, the app model gives platform owners first crack at exploiting these opportunities and the means to squeeze rent from 3rd parties that take their share. Because of this, we see the platform companies – Apple, Google, Microsoft, and maybe, Amazon – as the biggest winners in this paradigm shift. In contrast, 3rd party app providers, which may seem well positioned, will be very vulnerable to disintermediation by the platform owners. Only those with particularly well protected business models will be free to thrive.

Exh 8: Global Smartphone Production and Revenue, 2011-2015

Get Smartphone

The pending launch of Microsoft’s Windows8, no longer tethered to Intel’s x86 processor architecture and designed to compete as a thin operating system and exploit the capabilities of the cloud, marks the real end of the PC era. Inexorably, portable platform devices – smartphones, tablets and ultrabooks – will crowd out spending on more traditional form factors (Exhibit 8). Portable devices, generally cheaper than PCs but replaced more often, should maintain a strong growth trajectory offering a stiff tail wind to providers of component technology particularly suited to these products. ARM processors, 4G baseband and radios, flash memory, advanced displays, sensors, and smart antennas, amongst other parts, will be keys to driving device innovation with huge volumes for category winners.

We covered mobile processors and components in our October 31, 2011 piece: “Mobile Processors: Here, There, and Everywhere”

War and Peace

The rise of mobile platforms has been greatly abetted by availability of 3G and WiFi wireless connectivity. Multimegabit data speeds ended the compromise inherent in wireless web access, making the innovations delivered by smartphones apparent and useful to consumers. Current 4G LTE networks are capable of matching the speed of all but the fastest wired residential broadband, and technical upgrades to the standard could boost system speeds and capacities by a factor of more than ten. While these offerings could bring new dimensions to the portable platform experience and threaten the primacy of cable modem access, industry competitive dynamics threaten to squelch progress.

Exh 9: US Wireless Carrier Summary Metrics

With significant operating advantages by virtue of their superior spectrum holdings, U.S. wireless market leaders Verizon and AT&T have backed off of network investment, taken data prices higher in concert and added usage caps to deter traffic growth (Exhibit 9). Meanwhile, smaller competitors lack the spectrum, cost structure and capital to step into the breach. The market leading duopoly has seen cooperation pay off in historically strong return on capital, and give every sign that they intend to stay the course. Taken at their word, this scenario would be a serious speed bump in the progression of portable platforms, but there is reason to believe that the carriers will be shaken from their reverie.

Cooperation between rivals in high fixed cost, asset intensive businesses, like telecommunication networks or airlines, has a long history of instability. Wireless carriers world over have periodically banded to hold up prices and keep down device subsidies, with an unbroken record of long-term failure. One carrier always blinks, jumping at cheap promotional plans and generous subsidies to grab for market share. Arguably, the launch of the iPhone depended on just such behavior from AT&T, which gave up content control, supported unlimited data plans and agreed to record subsidy levels in order to secure exclusive rights. Given Verizon’s lead in LTE, it would be surprising if AT&T didn’t eventually take aggressive steps to play catch up.

Moreover, regulators may not sit on their hands forever. The current FCC has been active – blocking AT&T’s acquisition of T-Mobile, playing hardball on Verizon’s proposed deal for spectrum held by cable operators, and working to bring new spectrum to market for the benefit of competition. New spectrum auctions, even if they are still 2-3 years away, will be an interesting development. The spectrum in question, in the 700MHz band used by TV, is ample and attractive. The FCC is likely to set rules intended to limit Verizon and AT&T draw competitors to the table. While the smaller U.S. carriers, Sprint, T-Mobile, MetroPCS, US Cellular, Leap and others, may not have the financial wherewithal to go to the mat, we note that the deep pocketed portable platform players have very strong incentive to help. Apple, Google, Microsoft, Amazon, and Facebook, et al. are not likely interested in building their own wireless network, but all are losers should Verizon and AT&T strangle wireless data in its infancy. Just as Intel, Samsung and Motorola provided billions of dollars to Clearwire and Sprint in their ill-fated push to make WiMAX a viable 4G standard, Apple, Google or Microsoft could easily fund a wholesale LTE advanced network to be shared by the various second tier operators. Just sayin’.

Exh 10: AT&T and Verizon CAPEX and Cash from Operations as a Percent of Sales, 1984-2011

Even if we are confident that cartel-like behavior between leading carriers will deteriorate, the timing is less evident (Exhibit 10). As long as Verizon and AT&T can hold it together, they can deliver unusual returns, and the equipment vendors, tower companies and smaller rivals that exist in their wake will continue to suffer. A break would reverse the scenario to the detriment of the top carriers and the benefit of everyone else. We are inclined to expect the break sooner rather than later.

We covered telecom carriers and wireless broadband in our April 2, 2012 piece: “Telecom Carriers: Why Aren’t These Cyclicals Cycling?

Yes, Virginia, the Television Industry IS Vulnerable

The debate on the future of TV has become more of a shouting match. Silicon Valley types, raised on Use.net and Napster, look at the $90/month cable video bundle as an offense against logic and freedom that must inevitably fall to the might of the Internet (Exhibit 11). Cable executives and media analysts scoff, assured that everyone’s bread is buttered on the same side and that HBO and the NFL will never be free. In the midst of the intractable argument, we think advertising will determine the winner of the debate.

Exh 11: Consumer Spend on Multichannel Entertainment, 2000-2010

The pro-cable view is comforted by a recovery in TV ad spend out of the recession and by rosy projections trend lining growth in future years. At the same time, audience estimates for top programming are flagging as the number of television households, and, importantly, the amount of television watched by each household, are falling for the first time in history. Meanwhile, the number of eyeballs watching on-line video continues to grow at near triple digit pace, fertilized by the rapid spread of video-friendly tablets and internet connected television sets. Advertisers, a conservative lot, have taken note. On-line video advertising is now 5% of total video ad spending, growing 50% a year and achieving a 30-40% pricing premium over broadcast television (Exhibit 12). It is finally getting big enough to matter, just as on-line video purveyors have gotten serious about selling. A lot of TV advertising gets sold in advance, through a process known as upfronts. This year, YouTube, Hulu, Yahoo and others were there, pitching their ability to target specific viewers and make sure that they watch the ads vs. television networks with shrinking audiences and a serious problem with DVRs that let viewers fast forward right through the ads. We believe this hits home in 2013, once the big Olympics and Elections ad spending is over, with a serious and unanticipated hit to channelized television ad spending.

Exh 12: Advertisement CPM Ranges by Media, 2011-2012

Thus goes the self-reinforcing cycle: eyeballs attract advertising, advertising attracts more and better content, and content attracts eyeballs. It doesn’t mean mass cord cutting – at least not at first – but it does mean that the advertising life blood, which accounts for more than half of channelized television industry revenues, will slowly drain into the Internet. Networks that follow the money will gain advantage over networks that stay loyal to the golden goose, and the cable value proposition will suffer for it. This is good for the studios, leagues and talent behind the most compelling content. It is good for the portable platform owners, who stand to play gatekeeper for access to streaming video. It is bad for cable MSOs, satellite system operators and the networks that fail to act.

We’ve written extensively on multichannel television, content owners, and video advertising in 1H 2012: “Video Advertising: The Incredible Disappearing Audience,” “Television Networks: Betwixt and Between a World of Change,” “The Future of Video Advertising: Three-Screens, #hashtags, and Streams,” and “Multichannel TV: What, Me Worry?”

The Voyages of the Starship Enterprise

Enterprise IT has been on a 10 year mission to virtualize its data centers and is not far off declaring mission complete. Data center virtualization has been a boon to high end IT vendors – offloading processing from desktops to servers means virtualization software, more servers, more storage, and beefed up networks. It also means enterprises have been able to sustain their long-standing investment in infrastructure and application software.

Over the last two years, CIO priorities appear to have changed, at least according to surveys published by Gartner, IBM and others. “The Cloud” has shot up the list to the top spot, and anecdotal conversations confirm widespread evaluation of cloud options going on (Exhibit 13). For IT managers, this is a logical next step from virtualization, which has delivered serious value in reduced desktop spending and lower costs for user support, software upgrades and maintenance. Moving appropriate applications to the cloud offers even more cost savings, along with operational benefits that come from leveraging the inherent performance and collaborative advantages of distributing processing across the Internet. Even simply moving existing software onto a virtual machine running on a large scale hosting operation should yield savings, and taking the further step of transitioning to a purpose-built SaaS application can deliver significantly more.

Exh 13: Shifting Global CIO Technology Priorities Over Time

This is very good for hosting operations and cloud savvy SaaS vendors, but very bad for traditional IT. Cloud hosts don’t buy the high end, value-added, turnkey iron with all the bells and whistles favored by enterprise IT professionals accustomed to paying for a bit of hand-holding along with their servers, storage and switches. Cloud hosts, like Amazon, IBM, Microsoft, and Google, are the most sophisticated technology users on the planet. These companies buy at the commodity component level and have the boxes assembled to their own specifications. They write their own software on top of open source foundations. They install, manage and maintain all of the hardware and software themselves. As customers like this become the predominant source of IT spending growth, the impact on traditional IT will be dramatic and painful. Furthermore, as enterprise IT customers move their business to the cloud, the costs of maintaining traditional software will become ever more apparent, hastening the moment that they consider biting the bullet and moving to a modern SaaS-based approach. All of this benefits the cloud hosts, the SaaS vendors and the best vendors of commodity technology. The losers should be apparent.

We wrote about Enterprise IT and the cloud earlier this year: “Enterprise IT: Send in the Clouds” and “Virtualization and the Cloud: No Silver Lining Ahead for Enterprise Data Center Vendors”

Summing Up

Looking across the TMT landscape, we see nine growth categories – Portable Device Technology, Platforms, Wireless Broadband, Content, Advertising, Differentiated Cloud Services, Cloud Hosts/Consultants, Commodity Hardware, and Software-as-a-Service. We have parsed the large cap and small cap TMT universe to identify companies that we believe are well positioned to exploit the opportunities in these categories, and that are not overly exposed to the risks that we see inherent in the platforms of the old paradigm (Exhibits 14-15). We then screen candidates by their free cash flow yields and their projected sales growth, selecting model portfolios of representative stocks balanced across the growth categories (See Appendix).

Exh 14: Relative Performance Summary of Large Cap Tech Stocks by Category

Exh 15: Relative Performance Summary of Small Cap Tech Stocks by Category

While our approach has been successful over the past two years, the past 3 months have been weak, with our large cap portfolio underperforming the technology elements of the S&P500 by 500bp and our large cap portfolio underperforming the S&P600 tech elements by 160bp. This is in part driven by the high beta nature of the stocks in our growth categories and by a few stock specific controversies that played out in the quarter.

Large Cap Portfolio Changes

We are making two changes to our large cap model portfolio due to Open Text and Riverbed falling below our $3B threshold for large cap as of June 12, 2012. We are demoting Open Text to the small cap portfolio and removing Riverbed from our model portfolios all together. Netsuite, a cloud based Financials / Enterprise Resource Planning (ERP) software company, which has benefitted from spending shifts into the cloud, has outgrown our small cap portfolio and will move into the large cap roster. Also, we will add global advertising agency WPP (WPPGY). We believe advertising agencies will benefit from shifting spending into digital, as traditional advertisers seek more help in constructing hybrid campaigns. We are content with the rest of the portfolio despite poor returns from SanDisk, Nuance Communications, and NVIDIA. We believe all three will ride growth from portable devices. Though NVIDIA has some idiosyncratic issues also due to its exposure to graphic processors, we believe its ARM-based Tegra line will benefit from a string of mobile design wins announced earlier this year (Exhibit 16).

Exh 16: Sector & Sovereign Large Cap TMT Model Portfolio Performance New Constituents

Small Cap Portfolio Changes

We are also making changes to our small cap model portfolio (Exhibit 17). First, the aforementioned Netsuite is leaving the small cap model portfolio as its valuation now justifies tracking it along with other large caps. Next, we are removing Ubiquiti Networks due to controversy around the company’s business practices and relationships with distributors. We are also removing Take-Two Interactive largely around concerns with forward guidance offered by the company and its reliance on several hit franchises that have lost steam. Finally, we’re taking out Universal Electronics, which is exposed to the cable industry with its RF remote control business. We also believe that device integration and convergence will decrease demand for remote control equipment.

Exh 17: Sector & Sovereign Small Cap TMT Model Portfolio Performance New Constituents

We are adding 3D Systems Corp which specializes in three dimensional printers. This is a relatively new space in commodity hardware with plenty of potential in industrial and design applications. We also like Stratasys, which operates in the same market but chose to add DDD because of its stronger sales figures and historical and expected growth. Also, we are adding Responsys, a provider of SaaS software for cross channel marketing. We believe it is well positioned given adoption of the product by several leading advertisers and continued demand for marketing campaign analytics by the advertising community. We are also placing Open Text in the portfolio as we maintain our favorable view on software companies with products that discern complex and unstructured data sets. Finally, we are adding Entegris, a manufacturer of specialty materials for semiconductor manufacturing and critical contamination control solutions.

Appendix:

Exh 18: Top 50 US Stocks – Margin, Growth, and Relative P/E

Exh 19: Sales Growth versus P/E; Large Cap Companies rated 10 in Positioning for Growth

Exh 20: Sales Growth versus P/E; Large Cap Companies rated 9 in Positioning for Growth

Exh 21: Sales Growth versus P/E; Large Cap Companies rated 8 in Positioning for Growth

Exhibit 22: Small Cap Universe Screen by Category (Sorted by Fwd P/E)

 

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