TMT in 2Q12: Investing for a Three Platform World

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SEE LAST PAGE OF THIS REPORT Paul Sagawa / Artur Pylak

FOR IMPORTANT DISCLOSURES 203.901.1633 /.1634

sagawa@ / pylak@sector-sovereign.com

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September 11, 2012

TMT in 2Q12: Investing for a Three Platform World

  • In the three months since our last portfolio update, Apple and Google shares have risen more than 18% apiece, while the third and least established platform player Microsoft yo-yoed up and down before ending on a relative high note, up roughly 7%. As TMT investors pick sides for the emerging three-way battle, we continue to believe that the opportunity is more than big enough for all three to prosper and that each has a unique position of advantage and a distinct business model in which to root their success. Indeed, platform competition offers anti-trust air cover that may allow platform leaders far more leeway to concentrate value from the massive paradigm shift than had been available to Microsoft during the salad days of the PC. Against this, trillions of dollars of the economy will be disrupted by new devices, e-commerce, on-line advertising, streaming media, mobile payments, consumer services, on-line education, Internet medical consultation, cloud hosting, Software-as-a-service, and other products enabled by the new paradigm. We believe that the big three, along with companies well aligned to their future dominance, will disproportionally benefit from this. Along these lines, we are making modest changes to our model portfolios to reflect our evolving perspective on those beneficiaries.
  • We see platform owners as the primary beneficiaries of the generational paradigm shift underway in the TMT landscape. Our previous quarterly update reviewed our general thesis of massive disruption of traditional IT and consumer media by portable devices, wireless networks and cloud-based services. In this once a generation sea change, we believe that Google, Apple and Microsoft will leverage their platform control to consolidate a disproportionate share of the value being created. We also believe that the platforms of the previous era – i.e. PCs, Cable TV, Client-Server IT, etc. – will be displaced more quickly than most observers expect.
  • The opportunities created by the shift will grow to be worth trillions of dollars in annual revenues over the next two decades. The industries sparked by the ‘80’s shift – PCs, wireless devices and services, broadband, cable television, browser-based Internet, client-server hardware and software, etc. – generated $3.2 trillion in global annual spending, all of which is up for grabs again in the new paradigm. At the same time, new opportunities in areas like e-commerce, payments, advertising, education, health care, and others portend considerable opportunity for growth beyond displacing aging platforms.
  • Microsoft, Apple and Google are attacking the market with very different business models, adding to the likelihood that all three will be successful in sustaining their platforms. The three platforms proceed from different strongholds, with distinct weaknesses as well. Apple makes its money on device margins, leveraging its extraordinary design and marketing skills, locking in users for future upgrades and new product categories. However, it is a neophyte in distributed data processing infrastructure and cloud applications. Google is strong where Apple is weak, monetizing its dominance in cloud technology through advertising, but struggling to coax its fragmented device ecosystem to follow its direction and fighting off IPR attacks. Microsoft’s core business is enterprise software and it has the inside track as IT departments methodically move to the cloud, unfortunately it is very late to the game with consumers. Amazon, which monetizes through e-commerce and has a powerful distribution mechanism for its fledgling platform, represents a fourth business model and the only real hope for an alternative to the big three. These contrasts make the competitive conflicts less direct and reduce the likelihood of a winner takes all outcome.
  • We have bet on all three platform players in our Large Cap Model Portfolio, which continues to outperform the broader market. Our Large Cap Model Portfolio was up roughly 12% since our last update on June 12, outperforming the S&P500 by more than 370bp for the quarter. Google was the top performer, up 24.0% on strong 2Q12 results, with Apple up 15.0% over the same timeframe in anticipation of next week’s iPhone5 launch. Investors remain somewhat skeptical of Microsoft, which underperformed with 5.2% appreciation, despite upside earnings and the pending introduction of its Windows 8 and Windows Phone 8 platforms. This quarter, we are removing Priceline, which was a notable underperformer and faces growing competition, and SanDisk, which was a strong performer but could see decelerating demand going forward. We are adding Akamai (AKAM), which will benefit from the strong growth of streaming video, and Seagate (STX), based on our bullish view of the cloud storage opportunity.
  • Our thesis is challenging for small cap companies competing with platform players – our Small Cap Model Portfolio focuses on components and differentiated services. Our Small Cap Model Portfolio was up 7.2% since the last update, but underperformed the S&P 600 by 390bp. We are removing three stocks that were notable laggards and only peripherally related to our core thesis – Comscore, Super Micro Computer, and Digimarc. In their place, we are adding Brightcove (BCOV) which provides on-line video streaming solutions, Monotype Imaging (TYPE) is a leader in electronic fonts and text rendering, and OmniVision (OVTI) is one of two major suppliers of image sensors for portable devices.

Exh 1: SSR Large Cap TMT Model Portfolio Performance (Constituents Before Revision)

Exh 2: SSR Small Cap TMT Model Portfolio Performance (Constituents Before Revision)

Our Top Story Tonight …

We have been asserting our basic thesis, that a once-in-a-generation tectonic plate shift is transforming the entire TMT sector, for
nearly three years.
At the core of this thesis is our belief that operating platforms controlled by Apple, Google and Microsoft will dominate technology use at home, at work and at all points in between. The vigorous competition amongst the three companies at the platform level gives them remarkable leeway to agglomerate value within their own ecosystems. Unlike the PC era, where the DoJ forced Microsoft to keep the browser as a truly neutral window, the app model is tightly managed by the platform owners who favor their own by setting them as defaults or integrating them directly into the platform. As mobile operating systems spread as integrated cross-device environments encompassing the home and workplace, Google, Apple and Microsoft will have unprecedented power over their customers’ choices of applications and cloud-based services, and thus, marked advantage in claiming opportunities for their own.

The opportunities are massive. We estimate new paradigm TMT businesses can address $19T in global spending on electronics ($144B), advertising ($1.2T), retail ($14.3T), payments ($590B), and traditional IT ($3.6T). New opportunities to disintermediate traditional industries like education and health care could make hundreds of billions of dollars more addressable by on-line businesses. We also note that the three major platforms all start toward these opportunities from very different strongholds, with highly contrasting strengths and weaknesses. Apple has a powerful consumer device franchise built from its design and user interface prowess, but is far behind on cloud infrastructure and in addressing the needs of enterprises. Google laps the field with its distributed data processing capabilities and integrated cloud applications, but relies on an unruly OEM ecosystem and is making slow progress with the enterprise market. Microsoft rules the enterprise market but is quite late to the party with its portable platform and is chasing Google on the infrastructure front.

As a result, we expect that the competing platforms will not line up together against every opportunity, and that each will establish pockets of dominance within the broader rivalry. Apple will make its money by selling more high margin devices to its locked in and deep pocked customer base. Google goes for maximum market penetration because it intends to make its profits from cloud-based services and advertising as it levers its massive IT investment. Microsoft will rely on enterprise adoption, and its domination of email and productivity software, to propagate its platform to the consumer market while it looks to exploit the shift to cloud-based applications.

Given this, we are comfortable with all three platform leaders in our Large Cap Model Portfolio, which outperformed the S&P500 by more than 800bp over the past 3 months. We are making a slight adjustment, removing Priceline and SanDisk and adding Akamai and Seagate (Exhibit 1). Our Small Cap Model Portfolio underperformed its benchmark by roughly 250bp. Given our overarching thesis that the large cap platform owners will consolidate opportunities created by the changing landscape, stock selection is more difficult in this universe. We are removing Comscore, Super Micro Computer and Digimarc, and adding BrightCove, Monotype Imaging and OmniVision (Exhibit 2).

It’s NOT Just a PC Thing

Portable platforms are playing in a very big sandbox. The most obvious opportunities are old-style electronic devices that can be mothballed as smartphones, tablets and ultrabooks continue to roll up functionality. Some categories, like digital cameras, camcorders, MP3 players, and personal GPS navigation units, have already turned over in decline, as smartphones have integrated their base functionality directly into the one electronic device that is always in your pocket. As the functionality of the new portable devices continues to improve, these stand alone products appear on the road to join PDAs and pagers on the scrap heap of technology history. Recent weakness in consumer PCs is obviously the flipside of the stunning success of the iPad, as people have been quick to discover that most of their information needs are better served by a tablet (Exhibit 3). Similarly, as the price of low end smartphones comes down, the market for pre-smartphone feature phones is drying up. Looking ahead, other big categories – enterprise PCs, point-of-sale terminals, cable set top boxes, TVs, and other home audio/visual gear – are also in the flight path. Taken together, these devices are a $1.0T global addressable market today (Exhibit 4).

Exh 3: Gartner PC Market Revisions, Q4 2010 – Q2 2012

Exh 4: Addressable Markets: Devices and Hardware

But wait, that’s not all. Internet advertising is a $76 B dollar revenue stream, growing at 16% per year, but still represents just 16% of the global market for measured media advertising (Exhibit 5). Along the way, web ads have laid waste to newspaper classified advertising and yellow pages advertising, putting those venerable business models at serious risk. Radio advertising has been under pressure for years, with internet based alternatives poised to deliver the death blow. However, print and television advertising have remained robust, capturing nearly three quarters of total measured media advertising in the US. It would seem that this spending will be increasingly available to Internet-based businesses. Non-media advertising, like coupons, flyers, point-of-sale displays, loyalty programs, etc., is a $210 B annual market in the US, and despite Groupon’s public stumbles, should also be addressable to on-line players. In total, we see addressable advertising spending as roughly $380 B in the US and $1.2T globally.

Exh 5: Global Measured Media and Internet Advertising

Digital media is already a $21.9B per year global market, with MP3s and e-books strangling the economics of physical distribution. Advertising is next – e-magazines, social readers, newsfeeds, internet radio, and streaming video are beginning to siphon off the lifeblood of magazines, radio and television – with subscription fees and pay-per-use revenue models targeted as well. Channelized TV itself is a $479B global industry ripe for disintermediation (Exhibit 6).

Exh 6: Addressable Markets – Media/Entertainment

Personal financial services have a patchwork presence on the web, with on-line brokerages, like e-Trade, the most obvious success. Payments may be the next beachhead, with eBay’s paypal, Amazon Checkout, and Google Wallet heading up a fairly robust line-up of non-bank on-line payment mechanisms. Next up are mobile payments, with smartphones standing in for credit cards in traditional face to face transactions. Device manufacturers, payments processors and retailers have embraced Near Field Communications (NFC) as standard for handling secure wireless connections at point of sale, with necessary infrastructure deployment underway. Smartphones are intrinsically more secure than magnetic stripes and 16 digit numbers, and infinitely more convenient to users who can pay with a wave of their phone combined with a PIN. Eventually, retailers will be able to use the system to call up customer profiles for personalized service or to push in-store promotions to regular patrons. While the system would not cut out credit card networks, payments processors or banks at the start, mobile payments are a beachhead from which other elements of the chain may be eventually disintermediated. Payments, on their own, are a $160B business in the US and $590B globally. While it may seem fantastic to consider consumer banking as addressable by portable device platforms, at the dawn of the PC era, few would have suggested that residential telephone service or newspaper classified advertising might be vulnerable. In that context, consumer banking is a $750B business domestically and $3.7T globally (Exhibit 7).

Exh 7: Addressable Markets – Consumer Categories

E-commerce rates as a $680B global business already, but it’s a drop in the bucket compared to the $14.3 trillion in goods sold by traditional brick-and-mortar retailers. Category by category, retail chains are feeling the heat. Amazon’s success in books and media is the prime factor behind the death of once familiar retailers like Virgin Music and Borders. A push into electronics contributed to the demise of Circuit City and has Best Buy on the ropes. New emphasis on office products, housewares and apparel could put names like Staples, Bed, Bath and Beyond or The Gap on the endangered species list as well. While it is doubtful that e-commerce could entirely displace brick-and-mortar retail, increasingly fast delivery and widening cost advantages for on-line merchants may permanently change the scope, economics and purpose of traditional shopping. While Amazon’s enormous first mover advantage makes them odds on favorite to sustain leadership in e-commerce, the platform players are positioned to muscle in for a piece of the action. This inherent conflict with Apple, Google and Microsoft is the clear rationale behind Amazon’s expensive push into the tablet market.

There are other industries that could be ripe for disintermediation. On-line education is already a $70B field, but the current cost crisis in both K-12 and higher ed suggest opportunities to attack a bigger piece of the $940B education market with technology solutions flowing through portable platforms. Health care costs have become central to political debate in the US, and as commitments to increase access to more people butt into increasingly troublesome shortages of Doctors and other trained personnel, internet-based solutions may become a significant opportunity. On-line consultations could play a critical role in addressing these problems.

Finally, US enterprise data center IT spending is $37.5B annually, with a further $63B from the rest of the world (Exhibit 8). The fastest growing piece of that is investment by internet-based businesses, which have built huge distributed data processing networks based on emerging technologies that give
them enormous cost and performance advantages
over typical enterprise data centers. The leader in this regard is Google, which invented a range of important data processing standards – MapReduce (the inspiration for the open source Hadoop), Google File System, BigTables relational data base system, etc. – and created a radical redesign of the data center itself that gives it significant cost and performance advantage over every other organization on earth. Amazon, Microsoft and Facebook are in hot pursuit, with private enterprise data centers far, far behind. Over the past several years, the big internet data center operators have begun offering the use of their capabilities to commercial customers, with Amazon taking the lead in developing this market. While the enterprise market moves slowly – for example, mainframe spending still represents 2% of the total IT market – we expect the cloud to become the primary computing resource for enterprises over the next 20 years, putting the whole of that data center budget up for grabs.

Exh 8: Global Data Center Equipment Spending by Category

Many Ways to Skin a Cat

Taking a long view, we believe that the next 20-30 years will see the portable platform paradigm addressing trillions of dollars of opportunity, and that the app model gives Microsoft, Apple, Google, and maybe, Amazon enormous leverage in co-opting them for their own. With control over access to 3rd party on-line businesses, the platform owners can extract a share of revenues, favor their own solutions or even integrate that favoritism directly into the platform itself. Apple is launching their own maps solution integrated into iOS6 after 5 years of relying on Google Maps and is rumored to be toying with their own version of Pandora’s internet radio service. Google is integrating its own restaurant reviews, airline fare searches, media streaming solutions and payments systems directly into Android. Microsoft ties Windows Phone 8 to its dominant enterprise email and productivity software franchises, and is expected to integrate tightly with the xbox, which is morphing into a one-stop entertainment platform. Amazon’s new tablets are designed to serve advertising at regular intervals while centering the experience around its own electronic media services. You get the picture.

The question is, can all three would be platforms (and perhaps four, considering Amazon’s proprietary implementation of Android) prosper? We think the answer is a resounding yes. Not only is the opportunity set huge, but the combatants begin from distinct strongholds with sharply contrasting strengths, weaknesses and business models. From this, we expect each company to establish its own well protected domain of core users and sources of revenues, and for the now fierce competition at the device level to recede over the long run.

Exh 9: Known US Data Center Locations of Apple, Amazon, Google, and Microsoft

Apple’s DNA is in device design. From the original MacIntosh in 1984, Apple has stood for beautiful products with deeply intuitive user interface software and seamless interworking across products within the Apple world. Combined with preternatural marketing skill, Apple has built an empire on the iPhone and in the process, catalyzed the paradigm shift now remaking the entire TMT sector. From this, Apple has built a business model around earning extraordinary margins on an interlinked family of products that tie its customers to panoply of proprietary applications, ensuring future upgrades and enticing users to extend their experience into new product categories. While this strategy has been obviously successful, Apple’s device focus had contributed to their belated embrace of the cloud. The first iPhone was designed to rely on a Mac for synching and updates, much along the lines of the original iPod. Apple followed Android into over the air synching and updates. Apple is notably weak in its data processing infrastructure, now building just its third data center and relying on partners, like Akamai, to deliver its on-line content and applications to its users (Exhibit 9). As integrated applications rely more and more on cloud-based processing and storage, Apple will find itself playing serious catch up. We also note that Apple has not established any meaningful presence with enterprise IT, a hole that may prove more costly with time.

With 35 global data centers, hundreds of co-located caching locations, and millions of servers, Google is the largest and most sophisticated distributed data processing operation on the planet. This infrastructure, based on proprietary, bleeding edge software, hardware and data center design gives it substantial cost and performance advantages vs. all would be competitors. It is why Google can deliver a search on the letter “A” before you type the second letter in your query. From early on, Google has focused on advertising as its primary monetization vehicle, an approach that has been clearly successful, even as the company toys with other ways to make money. In this context, Android is a canvas upon which to paint advertising driven cloud services, given away for free to maximize the size of the eventual audience. By foregoing revenue from the device, Google looks to maximize penetration with its ecosystem of hardware partners. Of course, the downside of this approach is fragmentation at the device level, compounded by its partners’ struggles with patent litigation. Keeping its ecosystem on track, with sufficient profitability to drive continued innovation is a burden. Meanwhile, Google has only dabbled in extending its reach into the enterprise, with its mildly successful Google Docs productivity software and its newly launched cloud services still seeking competitive traction despite obvious cost advantages.

Microsoft is late to the portable platform game, but its timing may not be a liability with the slow to emerge enterprise market. While Microsoft will suffer from the decline of its Windows monopoly as the PC architecture fades away, it is well placed to compete for a new generation of enterprise devices based on portable platform concepts and leveraging the cloud. Unlike its prime rivals, Microsoft has longstanding relationships with IT decision makers and an ingrained understanding of their continuity and security concerns. As such, we expect Windows 8, Windows RT and Windows Phone to lead in the enterprise space, with application software, infrastructure software, and cloud hosting opportunities following in kind, in keeping with Microsoft’s traditional software licensing business model. At the same time, Microsoft is years behind iOS and Android with consumers, and despite the vested interest of device OEMs, carriers and application developers in supporting it as an alternative to Apple and Google, it may be a very long row to hoe to reach relevance.

Amazon recently doubled down with a new slate of aggressively priced tablets, based on the Android core, but presenting a wholly proprietary platform for its users. These tablets are sold at cost, designed as a funnel for Amazon advertising, content and on-line shopping. The upfront price and the unparalleled reach of Amazon’s retail operation give it a fighting chance of establishing a foothold as a fourth platform. Apple’s business model would not support a price war with Amazon, while Google and Microsoft must manage the profit needs of their OEM partners, perhaps leaving a significant window for Amazon to attack the mass market. Of course, Amazon’s focus on media distribution and e-commerce limits its platform to self distribution and a less comprehensive user experience, drawbacks that the company hopes are overcome by its aggressive price.

Stepping back, we see Apple staking out the premium product territory with expensive aspirational products and cross-device integration; We see Google going for mass market penetration to maximize its value to advertisers and to integrate cloud-based services into the base value proposition for users; We see Microsoft looking to leverage its enterprise software franchises and establish the upper hand as its longstanding customers slowly adopt portable technology; and we see Amazon pushing a super cheap line of tablets as conduits to its media distribution and e-commerce franchises. Given the size of the opportunities, we see no reason that all of these strategies couldn’t be successful.

The Large Cap Model Portfolio

Our Large Cap model Portfolio, centered on Apple, Google, Microsoft and Amazon, and including 11 other companies that we believe are well positioned against our scenario of sea change and platform domination, performed very well over the past 3 months, beating the S&P 500 benchmark by more than 400bp. Google was the biggest winner, up 24% for the quarter, just ahead of NetSuite, which appreciated 22.7%. Amongst the other platform plays, Amazon rose 19.4% on strong quarterly numbers, with Apple continuing its longstanding tear with nearly 16% improvement. Notably, Microsoft was a bit of a laggard, up only 6% vs. the 9.5% rise in the S&P500, perhaps owing to ongoing skepticism in its efforts to establish itself as a platform alternative to iOS and Android (Exhibit 10).

Exh 10: SSR Large Cap TMT Model Portfolio Performance (Constituents Before Revision)

We are making changes to the portfolio composition. Priceline had been a reasonable performer since it was first included in the Large Cap Portfolio in Ma of last year, but we believe that Google’s move to integrate airline flight comparisons to its core search product will squeeze the opportunity for on-line travel agents, and that Apple’s launch of its Passport ticket application for iOS6 portends a similar move on its part in the future. Likewise, SanDisk is up 32% since we added it to the portfolio a year ago, but we believe that the shift to cloud-based applications will limit the need for flash capacity on new paradigm devices in the future. We are removing both companies.

Exh 11: SSR Large Cap TMT Model Portfolio Performance (After Revision)

In their place, we are adding Akamai (AKAM) which is the primary CDN provider for Apple. As Apple looks to add streaming media services to its platform, it will need to rely on partners for the infrastructure necessary to provide quality performance for its customers. With the volumes that an Apple streaming service might require, Akamai is in a strong position to benefit. We are also adding Seagate (STX) (Exhibit 11). Disk drives have been heavily cyclical in their performance over time, and investors have been reticent to step up given the obvious downside to demand from PCs as disk drive free tablets gobble up market share. However, cloud data center operators, led by Google, are implementing storage strategies that employ sheer disk drive capacity as their primary back up mechanism, storing information four times over rather than managing for reliability with a lower degree of redundancy. With the growth of these cloud operators, we expect demand for commodity disk drives to expand longer term, with further benefit from the recent consolidation of the industry down to just three competitors.

Exh 12: SSR Small Cap TMT Model Portfolio Performance (Constituents Before Revision)

The Small Cap Model Portfolio

The Small Cap Model Portfolio underperformed the S&P 600 benchmark by about 350bp for the past 3 months. Given our thesis of platform domination, stock selection is more difficult in the small cap universe, a factor that may be contributing to the recent underperformance. The notable winners for the quarter included Fusion I/O, which was up over 50% , Itron (+28%), 3D Systems (+22%) and Open Text (+18%). On the downside, Responsys fell 19%, Super Micro Computer declined 14%, ComScore dropped 13%, and Digimarc was off 10%. We are removing the latter three stocks (Exhibit 12). In their place we are adding BrightCove (BCOV) which provides streaming video services for a number of major network customers, Monotype Imaging (TYPE) which is the leader in electronic fonts, and OmniVision (OVTI) which had been an original component of our small cap portfolio and is the second largest provider of photographic image sensors for smartphones (Exhibit 13).

Exh 13: SSR Small Cap TMT Model Portfolio Performance (After Revision)

Appendix

Exh 14: SSR Large Cap TMT Screen

Source: Capital IQ, SSR Analysis

Exh 14: SSR Large Cap TMT Screen (Continued)

Source: Capital IQ, SSR Analysis

Exh 15: SSR Small Cap TMT Screen

Source: Capital IQ, SSR Analysis

Exh 15: SSR Small Cap TMT Screen (Continued)

Source: Capital IQ, SSR Analysis

Exh 15: SSR Small Cap TMT Screen (Continued)

Source: Capital IQ, SSR Analysis

Exh 15: SSR Small Cap TMT Screen (Continued)

Source: Capital IQ, SSR Analysis

Exh 15: SSR Small Cap TMT Screen

Source: Capital IQ, SSR Analysis

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