BERENBERG EQUITY RESEARCH Global Technology Nemesis: a source of harm or ruin? Adnaan Ahmad Analyst +44 20 3207 7851 [email protected]Jean Beaubois Specialist Sales +44 20 3207 7835 [email protected]21 May 2013 Technology Hardware Daud Khan Analyst +44 20 3465 2638 daud.khan @berenberg.com Ali Khwaja Analyst +44 20 3207 7852 [email protected]Tammy Qiu Analyst +44 20 3465 2673 [email protected]Sebastian Grabert Analyst +44 20 3207 7834 [email protected]
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Global Technology - berenberg.de ZTE, Huawei, NSN, Alcatel-Lucent, Samsung and now potentially vendors such ... Global Technology of. Adnaan Ahmad Analyst +44 20 3207 7851
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For our disclosures in respect of section 34b of the German Securities Trading Act (Wertpapierhandelsgesetz – WpHG) and our disclaimer please see the end of this document. Please note that the use of this research report is subject to the conditions and restrictions set forth in the disclosures and the disclaimer at the end of this document.
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Table of contents
Nemesis: a source of harm or ruin? 4
ARM has more legs 16
What is working 19
ARM 19
Infineon 20
Samsung Electronics 21
Apple 22
Qualcomm 23
Imagination 24
HTC 25
Foxconn International 26
Hon Hai 27
Juniper 28
Motorola Solutions 29
Foxconn Technology 30
What is not working 31
Ericsson 31
STMicro 32
BlackBerry 33
Nokia 34
Alcatel-Lucent 35
ZTE 36
TPK 37
Catcher 38
MediaTek 39
Cisco 40
Price targets and valuation 41
Disclosures in respect of section 34b of the German Securities Trading Act (Wertpapierhandelsgesetz – WpHG) 42
Contacts: Investment Banking 48
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Nemesis: a source of harm or ruin?
Since we initiated on the sector in January 2010, we have talked about the battle between the Apple and Google (Android) ecosystems in the post-PC era. To date, this battle has primarily been along classical tech hardware business and financial models: come out with a good device and sell it at as high an ASP as possible to try to be profitable. Amazon disturbed this business model somewhat with its Kindle Fire launch in late 2011 and Google (with its Nexus line) has used a similar strategy on occasions. However, we see the next 12 to 18 months as a potential watershed for the classical hardware profits business model as Google, Amazon and potentially Microsoft and others introduce smartphones and tablets with a “hardware at cost or a loss” strategy.
The issue here, in our view, is that if any of these “platform vendors” are successful with large consumer uptake, which admittedly has not been the case to date, then this will put a major strain on the margin dynamics of the hardware industry. We think Google’s “X” project (new smartphones and potentially tablets), coupled with the possibility of an Amazon smartphone, should be “front and centre” in investors’ minds when thinking about hardware industry margin structure in the mid-term, as these platform vendors can leverage their existing advertising, content and e-commerce financing models to offer high-end smartphone quality at up to 50% cheaper than equivalent devices from Apple, Samsung and the traditional hardware industry. Good for consumers, but also positive for telcos as they will be able to substantially lower their current subsidy levels on high-end devices.
We remain convinced that competition among traditional vendors, feature creep, the shift to lower-priced devices, slower industry growth and the potential of new platform players as described in this note will put pressure on smartphone industry margins. We keep our bearish structural views on Apple, Samsung, HTC, Nokia, BlackBerry and ZTE.
We also keep our negative stance on the infrastructure and networking segment. Yes, it has been the wrong call in the last six months; and yes, 2013 may be a positive spending cycle primarily driven by the US and Europe. But the cycle, in our opinion, will be overpowered at some point in the next 12 months by the structural headwinds that face these industries. Ericsson, ZTE, Huawei, NSN, Alcatel-Lucent, Samsung and now potentially vendors such as Cisco will hit the space from a small cell/WiFi angle. This, coupled with telecoms companies’ continued contradictory spending behaviour, should lead to further industry restructuring, exits and consolidation, in our view. Capacity needs to come out of the industry, we believe.
ARM Holdings therefore remains our only Buy-rated stock. Royalty rate inflation and end-market diversification remain the core tenets to our thesis here, and we raise our price target to £13.50.
In this note, we discuss the potential for platform players to turn the hardware business model on its head by using “hardware at cost or a loss” strategies aggressively to gain share in smartphones and tablets. Platform players continue to face challenges – such as distribution, core expertise and product innovation cycles – but we think it is important to highlight the threat of such strategies, especially to the smartphone industry and its margin structure given the upcoming launch of Google “X” products in the next six to 12 months.
Finally, given our negative stance on all but one stock in our coverage universe on an absolute basis, we continue to highlight certain pair trades (see table below) and note that to date they have performed well. In this report we also assess, as always, what is working and what is not from a stock perspective. Our detailed updated models for each company are available on request.
Pair trades return between inception and 16/05/2013
Pair trades-return between inception and 16/05/2013
Long Short Return
QCOM MTK -11.1%
IFX STM -16.7%
ERIC ZTE -5.7%
Samsung HTC -8.9%
ARM IMG 45.8%
TPK FIH -2.5%
AAPL Samsung 3.5%
Nokia HTC 0.4%
CSCO ALU 6.1%
ERIC JNPR 10.2%
Source: Bloomberg data
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Berenberg versus consensus estimates
Source: Berenberg estimates, Bloomberg for consensus
Change in EPS estimates
Source: Berenberg estimates, Company data
Companies Berenberg Est. Consensus Delta Berenberg Est. Consensus Delta
Nokia -0.01 0.00 -348% 0.08 0.11 -20%
Ericsson 4.84 4.84 0% 5.26 5.87 -10%
Alcatel Lucent -0.26 -0.14 -86% -0.03 0.02 -227%
Apple 40.93 39.75 3% 39.79 44.03 -10%
BlackBerry* -0.35 0.37 -195% -0.61 0.02 -3884%
Infineon 0.23 0.21 8% 0.31 0.38 -19%
STMicro -0.02 0.06 -136% 0.29 0.41 -29%
ARM 0.22 0.20 12% 0.29 0.25 15%
HTC 8.86 14.61 -39% 11.79 19.67 -40%
ZTE -0.20 0.58 -134% -0.13 0.73 -117%
Motorola Solution 3.50 3.62 -3% 3.71 4.19 -11%
Cisco 2.02 2.01 0% 1.97 2.12 -7%
Juniper 1.06 1.14 -6% 1.07 1.29 -17%
Qualcomm 4.39 4.54 -3% 4.65 4.90 -5%
Mediatek 16.71 18.17 -8% 17.00 23.27 -27%
Catcher 16.70 16.11 4% 14.23 15.85 -10%
Hon Hai 7.32 8.08 -9% 6.91 9.04 -24%
TPK Holdings 52.70 52.07 1% 52.10 56.87 -8%
Foxconn Technology 6.58 7.06 -7% 6.74 7.47 -10%
Foxconn International Holding -0.01 0.00 -123% -0.01 0.02 -185%
##18 BBRY ($) Sell 5.0 14.7 -66% 39.6 Increase in competitive intensity in US market
## New BB10 platform not a game-changer
## Services revenues to come under attack
19 Hon Hai (NT$) Sell 66.0 78.7 -16% 9.7 45% of revenues from Apple and over 75% of Hon
Hai's growth from Apple
## Apple won't subsidise forever
## Apple concentration a double-edged sword
20 Foxconn Intl Sell 2.5 3.3 -24% n/a Headwinds for Nokia, Motorola and Sony
## (HKD) Nokia may outsource more assembly to Foxconn but
that is in price
##21 Nokia (€) Sell 1.5 2.9 -48% 970.0 NSN in harvest mode a positive
## Samsung + Android (China Inc) big threat to
## Nokia's mid-to-low-end emerging market position
22 HTC (TWD) Sell 150.0 290.0 -48% 19.8 "One" Series will only provide short-term relief
## Samsung, Apple into mid-range smartphones
HTC margins will be under pressure
## New markets at an investment cost; eg China
Buys - 16
Holds - 8
Sells - 6
Buys - 7
Holds - 3
Sells - 4
Buys - 19
Holds - 7
Sells - 21
Buys - 9
Holds - 9
Sells - 15
Buys - 8
Holds - 7
Sells - 5
Buys - 15
Holds - 9
Sells - 4
Buys - 2
Holds - 12
Sells - 8
Buys - 9
Holds - 11
Sells - 2
Government business to face challenges given catch-up
spend fall-off in next 12 months. Enterprise business
under pressure given retail capex concerns
Buys - 8
Holds - 12
Sells - 21
Buys - 8
Holds - 14
Sells - 2
Buys - 13
Holds - 21
Sells - 5
Buys - 7
Holds - 12
Sells - 10
IP business strong but competition intensifying
Cost savings will be given back in pricing
Buys - 13
Holds - 14
Sells - 7
Buys - 19
Holds - 5
Sells - 4
Buys - 51
Holds - 14
Sells - 3
P/E 2013E Consensus Investment thesis
Buys - 13
Holds - 11
Sells - 6
Buys - 18
Holds - 12
Sells - 6
Buys - 38
Holds - 9
Sells - 4
Buys - 22
Holds - 9
Sells - 5
Buys - 23
Holds - 4
Sells - 5
In-cell technology should replace glass on glass in mid-
term. Apple (55% of TPK revs) is likely to go down this
path in the next 18 months
Buys - 43
Holds - 4
Sells - 2
Buys - 49
Holds - 0
Sells - 2
% Implied
upside/
downside
Company Rating PT Price*
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Nemesis: a source of harm or ruin?
Nemesis: “A source of harm or ruin”; “an opponent that cannot be beaten or overcome”. The Free Dictionary.
First, since we initiated on the sector in January 2010, we have talked about the battle between the Apple and Google (Android) ecosystems in the post-PC era. To date, this battle has primarily been along classical tech hardware business and financial models: come out with a good device and sell it at as high an ASP as possible to try to be profitable. Amazon disturbed this business model somewhat with its Kindle Fire launch in late 2011 and Google (with its Nexus line) has used a similar strategy on occasions. However, we see the next 12 to 18 months as a potential watershed for the classical hardware profits (thin margins) business model as Google, Amazon and potentially Microsoft and others introduce smartphones and tablets with a “hardware at cost or a loss” strategy.
Historically, on occasions, hardware vendors have used their strong profitability with these products to “subsidise” services businesses. For example, Nokia had operating margins in the 20% range for its handset business and tried unsuccessfully to create ecosystems (Club Nokia/OVI); these proved to be loss-making. Even Apple’s Services businesses (App Store and iTunes) have only 5% margin structures. Samsung is trying to do that today by investing its “super-normal” margins in smartphones into software and services. On the other hand, Amazon initially made between a $30-50 loss on each Kindle Fire it sold (ie on the hardware) in Q4 2011, but its model was to make that money back – and then some – through subscription, services and content. Google made losses on some of its Nexus products, but that was to propel the wider Android market into an accelerated product introduction and development mode. And more recently, we think that Microsoft has been and will “subsidise” its “Surface” and “Surface Pro” efforts to push Windows 8 concepts into the mainstream. The issue here, in our view, is that if any of these “platform vendors” are successful with large consumer uptake, which admittedly has not been the case to date, then this will put a major strain on the margin dynamics of the hardware industry. We think Google’s “X” project (new smartphones and potentially tablets), coupled with the possibility of an Amazon smartphone, should be “front and centre” in investors’ minds when thinking about hardware industry margin structure.
Second, given that the bill of material on high-end smartphones (such as a Samsung Galaxy S4 or an iPhone5) is in the $250-300 range, if Google, for instance, prices its “X” device at near cost, then that will be 50% cheaper than the equivalent high-end device. This is obviously good news for the consumer, but also very good news for telcos as they will be able to substantially lower their current subsidy levels on high-end devices. In this scenario, Apple and Samsung could obviously stick to their existing pricing structure and hope that their brand and/or ecosystem will deflect consumers from churning, but the likely outcome, in our view, would be to lower their respective prices and, at the same time, beef up cost (marketing to offset operator advertising of the lower-priced Google “X” as well as
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accelerate new product development). This is the issue that confronts hardware-centric vendors – how do you compete against companies that (given their business models) can offer hardware for free? Nokia, LG Electronics, BlackBerry, Sony Mobile, HTC, China Inc and Japan Inc are all struggling to make decent profits/returns in the smartphone business. The same is true in the PC space for Dell, HP, Acer, Asus, Toshiba and Sony. And in the tablet (hybrid/convertible) segment, both groups are also at best operating on razor-thin margins. The exceptions are obviously Apple and Samsung, which between them account for more than 100% of smartphone and tablet industry profits today. At the same time, though, given their generous margins (we estimate that Apple makes ~30-35% operating margins in its iPhone business and Samsung just posted Q1 2013 margins of ~20% for its IM division, which houses its smartphones), they both have the most to lose.
PC and handset vendor margin structures in 2012
Source: Company data, Berenberg estimates
Third, the business and financial models of hardware companies and these platform companies are very different. Google’s business model is predicated on amassing advertising revenues based around its technological advantage in search, whereas Facebook’s is centred on leveraging its social network platform. Similarly, Amazon’s model is e-commerce revenues and razor-thin margins. Microsoft’s model is licensing Office and OS purchases of Windows by hardware OEMs. The important point here is that each of these vendors can leverage their “existing” profitable platforms into the hardware space. If we look at history, Microsoft was ploughing investment into its Xbox hardware and this division was losing money hand over fist between 2005 and 2008, with -20% to -30% operating margins. But
Gross Margin Operating Margin
Nokia (Devices & Services) 21.3% -4.5%
LG Electronics (Mobile) n/a 0.2%
BlackBerry (Hardware) 1.0% -8.0%
HTC 26.0% 7.0%
ZTE (Handset Business) 16.8% 5.0%
Sony (Mobile & Products) n/a -7.9%
TCL Communications 17.4% 0.0%
Toshiba (Electronics Division) n/a 6.8%
Dell (PC ) n/a 3.2%
HP (Consumer & Products) n/a 4.7%
Acer 10.1% 0.2%
Asus 13.6% 4.9%
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Microsoft, with its deep pockets, persisted – which will be the case again in tablet and potentially smartphone hardware, in our view. In addition, Amazon selling a Kindle Fire at cost or at low single-digit margins is: a) around the corporate average margin structure; and b) a way to incentivise the hardware user to buy more products digitally from Amazon. In other words, these platform vendors want to drive software, services, content and subscription sales. Hardware vendors do not have that luxury. Even Apple, with ~8-10% of revenues from digital content (App Store and iTunes) will need to change tack if these platform vendors are successful with their “hardware at cost or a loss” strategies. A final interesting anecdote is that Motorola Mobility currently has negative margins; hence potentially selling new Google-inspired hardware at near-cost could actually be a positive boost to overall group margin structure!
Platform players have deep pockets to pursue “hardware at cost/a loss” strategy
Source: Company data 2012
Fourth, the platform we worry about the most is Google. According to an article in the Wall Street Journal (21 December 2012), Google’s CEO, Larry Page, has told the Motorola team to “think big” and aspire to reach the scale of Samsung’s mobile business; and promised a significant marketing budget for the unit. In the past 18 months, the Motorola products that have been launched have all been Motorola-inspired. In the next six to 12 months, we think hardware products that come out of Motorola will be Google-designed and a branded Google experience.
Commentary from Google’s earnings call in April also points to some new products. Page said: “In today’s multi-screen world, the opportunities are endless. Think about your device. Battery life is a challenge for most people. You shouldn’t need to carry around a charger with you to make it through the day. If your kids spill their drink on your tablet, the screen shouldn’t die. And when you drop your phone, it shouldn’t shatter. There is real potential to invent new and better experiences, ones that are much faster and more intuitive. So having just seen some of those upcoming products myself, I’m really excited about the potential there.” We think that these remarks
Platform Players have deep pockets to pursue "hardware at a cost/loss" strategy
Amazon Google Microsoft Facebook
($)m
Revenue 61,093 50,175 73,723 5,089
Gross Margin 25% 59% 76% 73%
EBIT 676 12,760 28,496 538
SG&A 9,723 9,988 21,426 1,788
R&D 4,564 6,793 9,811 1,399
FCF 395 13,346 29,321 377
Net Cash 7,063 44,020 51,096 7,270
Source: Company Data
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pertain to the much-discussed Google “X” product series, which we think could launch in H2 2013.
We also think that the origins of Google’s more aggressive hardware approach and an intention of its acquisition of Motorola Mobility could have been to replicate the “forking” strategy Amazon used with Android. In a nutshell, when Amazon launched the Kindle Fire in H2 2011, it “ostracised” Google. The problem for Google was that the Kindle Fire did not – and still does not – come installed with Google Play. It uses its own browser “Amazon Silk” and the “Amazon App Store”, through which Kindle Fire users can also access apps; ie it is Amazon that is driving the user experience. Obviously, we do not know the nature of the deal between Google and Amazon, but we note that Google monetises Android through the following methods: a) channelling mobile users to use its search engine. Google Search is the default search system on the Android OS, which leads directly to greater revenues from search-based ads; b) taking a transaction fee of up to 30% for each app sold through its Google Play; c) displaying in-app advertising through AdMob; and d) Google is also working on initiating location-based advertising in Android smartphones. It recently launched Google Wallet for mobile payments and would gain by either charging transaction fees or for ads. Obviously, with Amazon in the “hot seat”, we believe only option a) is currently certain for Google from Kindle Fire users. We note that Amazon’s business model is to get Kindle Fire users to subscribe to its “Prime” service at $79/year, which gives US, European and Japanese users the ability to tap into thousands of videos and unlimited fast shipping. In the US, “Prime” users tend to spend up to 2x more with Amazon than the average Amazon user; hence the company wants to “digitise” and grow this “Prime” user base over time. In conclusion, we think the Amazon “Android work-around” opened a “crack” in the ecosystem and Google decided to hedge its current horizontal model versus the Amazon Android model if: a) Amazon were successful; and b) others were to move to an Amazon-like model.
There are some interesting ramifications for the industry if Google launches such a product with a big distributor and telco push.
a) A top-of-the-range smartphone, Google “X”, at $300-400 versus the $600 level of the iPhone5 and Samsung Galaxy S4. Telcos, we think, will push this product given the potential for lower subsidies as Google leverages its “platform” and “hardware at cost or a loss” strategy.
b) Could this split or “fork” Android? HTC, LG Electronics, Sony Mobile and Samsung would obviously be the initial casualties if the Google “X” gains consumer momentum. LG Electronics has recently talked about a turnaround in its smartphone business; Sony expects its smartphone division to be profitable by year-end March 2014. HTC has its future riding on the “ONE” phone and Samsung has nearly 50% market share in the Android ecosystem. We think that ZTE, Huawei and China Inc will be less affected as they compete primarily in the low-priced smartphone segment and Google obviously has “brand” issues in China.
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c) Samsung would clearly be a major casualty given the business model difference as well as its high-end smartphone market share. Samsung is obviously in an interesting situation as it commands 50%+ share of Android smartphones and hence Google does need Samsung to continue to succeed in the short term. Interestingly, though, Samsung has upped the ante on software and services initiatives as well as publicly talking up its “hedged” OS strategy: Tizen and Microsoft. However, both of these are essentially starting from scratch, and if Samsung tries to “fork” Android like Amazon, how will it gain critical mass in content, services and subscription? Ultimately, Samsung is a very good hardware company; shifting to become a “platform” company will be extremely difficult – look what happened to Nokia with its OVI venture. Another point here is that Google is ultimately the key-holder to Android: Samsung has absolutely no control of the evolution of the platform (and hence its attractiveness to developers) and Google Play (and hence its attractiveness to end-customers).
Smartphone market share development by operating system
Source: IDC
2008 2009 2010 2011 2012
Android 0.5% 4.0% 23.3% 49.2% 68.8%
iOS 9.1% 14.5% 15.6% 18.8% 18.8%
Blackberry OS 15.6% 19.9% 16.0% 10.3% 4.5%
Symbian 48.4% 44.9% 36.4% 16.5% 3.3%
Windows Mobile 13.0% 9.3% 4.9% 1.8% 2.5%
Other 13.4% 7.4% 3.8% 3.6% 2.1%
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Tablet market share by operating system
Source: Gartner
Fifth is Amazon’s strategy. “We want to make money when people use our devices, not when they buy our devices,” Jeff Bezos, CEO of Amazon, said. The Kindle Fire is Amazon’s first step into the hardware world, in our view. We think that over the next 12 to 24 months, it is likely that Amazon will launch a smartphone, allowing it to leverage its platform and “hardware at cost or a loss” strategy further. As stated above, Amazon has its own “flavour” of Android and its own App store; and it is working on building an ad network through the applications it distributes. The bottom line: it is all about selling as much digital content and Amazon merchandise as possible. It has created cloud and streaming-based services for films, music and video, which it offers to customers with cloud storage and potential shopping and/or shipping discounts. We think that the key differentiator with Amazon is that it sells virtually everything, and mostly at very competitive prices. The potential for an Amazon-based smartphone has been discussed for a while but there are some pointers to suggest that it is real – smartphone screen sizes are increasing, which benefits the Amazon shopping experience. Amazon has recently hired Microsoft phone teams, the leader of which stated: “I’m building a new team going after a totally new area for Amazon. I’m hiring cloud and mobile developers and testers, program managers, and product managers.” Amazon has also acquired Liquavista (a display technology company) and a natural voice search company (think SIRI on Apple). We also know that it has been trying to gain access to wireless patents to potentially protect itself against any hostile onslaught.
Sixth, Microsoft is obviously the elephant in the room. It is very late to the game versus its platform peers, but it has shown before in the game console business that it has deep pockets and is willing to go through near-term pain for a position on the podium. Microsoft’s dabbling in hardware has been an unmitigated disaster, in our view, with the exception of the Xbox in the last few years. The “Kin”, “Slate” and “Zune” come to mind, and the “Surface” will probably go down a similar path. The more immediate issue with the “Surface” is how it “alienated” Microsoft’s historical hardware OEM partners (such as HP, Dell, Lenovo, Acer and Asus). In this instance, the “hardware at cost or a loss” strategy failed to take any volume share away
2010 2011 2012
Android 15.9% 30.7% 42.9%
iOS 83.7% 65.3% 55.8%
RIM 0.0% 0.2% 0.3%
Windows 0.0% 0.0% 0.9%
Others 0.4% 3.8% 0.0%
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from the traditional hardware community. The question now is does Microsoft follow a similar hardware strategy and come out with a “Surface smartphone”? We do not think that it is on the cards in the next 12 months, given: a) Microsoft needs hardware friends to garner volume and an ecosystem for Windows 8 and Windows Phone 8; b) Windows 8 is still in its infancy and there are already many user complaints on changing the OS or making it easier and less confusing; hence we think that this shift to “Windows Blue” is a priority in the near term; and c) Microsoft recently stipulated that it was not interested in building its own smartphone.
Seventh, there have been many statements about Facebook coming out with its own hardware and leveraging its social network platform and user base. We do not think that this is likely in the next 12 to 18 months given that the company needs to achieve increased usage on as wide a hardware base as possible rather than having two to three Facebook-branded smartphones. It has relationships with Apple, Microsoft, Google and BlackBerry, as well as with lower-end phones, such as Nokia’s Asha series. The mobile business is critical to Facebook’s future and its current valuation, as can be shown by the push to get “Home” on Android-based devices. Unfortunately, this initiative has not taken off and neither did Facebook’s button on HTC “Salsa” and “Cha Cha” phones in 2012.
Eighth is the position of other possible platform players. BlackBerry is obviously a niche platform currently with its own hardware, software, services and applications. As we have stated since our 2010 initiation, we just do not see how BlackBerry survives in the mid-to-long term. Similarly, Sony has hardware (smartphones, tablets, PCs, TVs), it uses Android but can “fork” it like Amazon, and it has a vast content library of music, gaming and films to leverage. The problem here is that Sony just has not been successful and is late at integrating this portfolio of assets into a powerful platform. In China, there are a few companies to be aware of that have a platform or quasi-platform approach, all based on variants of Android. Xiaomi sells high-end handsets online at ~50% discounts to its peers as it strives to make the money back with Internet/messaging services and accessory sales. It shipped over 7m handsets in 2012. Baidu, China’s Internet search giant, also uses an Android variant (Baidu Cloud) and works with TCL and Changhong to sell smartphones at RMB1,000 ($150). Sina, Alibaba and Tencent have also experimented with platform and content partnerships with hardware OEMs in the last two years but to date have not released any of their own branded devices.
Ninth, if Google, for example, is successful with a smartphone product in the next 12 months, then one definite conclusion is that volumes in smartphones may be higher than investor expectations, as demand is brought forward on the back of lower price. This is obviously good for ARM and Qualcomm’s QTL licence business. The history of consumer electronics dictates that lower-priced devices do pull mid- and high-end prices down over time. In the near term, investors may be focused on the larger pie, but they should also start thinking about how this affects Apple and Samsung mid-term. A Google platform as a competitor is a very different animal to a “horizontal” Google business model, as it surely would depress industry and hence Apple and Samsung margin structures. This is
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already the case with the iPad in general and the iPad mini in particular, which Apple has stated has significantly lower than corporate average margins. As smartphones proliferate into the mid- and low-end in the next two to three years, there is a natural mix impact on margins, there is a feature creep impact (ie pack in more “bells and whistles” without the offsetting price uplift), and there is the competitive aspect – traditional competition from China Inc and Samsung, but also platform competition.
And finally, what are the potential pitfalls for the platform players? Well, telcos that have launched branded devices have historically failed to gain any real traction. Distribution, brand, new product innovation and scale have been challenges for the telco community. Distribution is obviously key for platform vendors. Microsoft’s “Surface” was only distributed initially via its own retail stores (a handful) and online. And distribution may only be tied to where the platform provider has sufficient content; ie Amazon does not offer “Prime” services and content in China. Securing telco and retail backing will be critical for any push in the smartphone segment. Low-priced devices could also only attract price-conscious consumers – hence the model to leverage content, services, subscription is only justified if the consumers actually go ahead and purchase these products!
ARM Holdings plc Technology Hardware
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ARM has more legs
The key to ARM’s stock and valuation, in our view, is royalty revenue growth over the next three to five years. Obviously, this is a function of volume, chip ASP, royalty rate and market share. We have a very simple model looking at how 2012 royalty revenue was made up and where we think smartphone, tablet, networking, server etc. volumes will trend to 2016. Our conclusion is that consensus estimates of $950m in 2016 are 16-35% too low for Processor division (PD) royalty revenues; and hence even though the stock has more than doubled from its low in 2012 (£4.50), there is still further upside potential based on underlying fundamentals as well as the option value of a possible acquisition of ARM. We increase our price target to £13.50 based on our new forecasts, encapsulating 25-30% annual average PD royalty revenue growth 2013-16, with consequent operating margin leverage.
Outside of valuation and macro, we believe investors’ biggest concern with ARM is the potential threat from Intel, as Intel shrinks to 14nm node in the next two years and implements its 3D technology aggressively with a goal to markedly improve its performance per watt relative to the ARM ecosystem. This is also our biggest concern with the stock. The issue for Intel, though, is that it needs to be able to deliver a product that has: a) vastly superior technology; b) is very competitive on price; c) is able to break into the ARM ecosystem (ie smartphone and tablet industries are primarily based on ARM architecture); and last but not least d) attract the captive semi vendors to switch – Apple, Samsung and Huawei.
The problem for Intel is that: a) ARM is not standing still with its own technology innovation (for example, Big.Little processors); while b) ARM’s ecosystem partners, TSMC and Samsung, are also moving ahead with 3D/FinFet and 2x and 1x nm process technologies. In addition, if we look at the industry structure on the hardware OEM side, wireless chip vendors need to gain traction with Apple, Samsung or China Inc.
Apple is obviously using its own designers to differentiate its chip architecture and will also slowly – over a two-year process, we think – transition semiconductor foundry activities away from its arch rival, Samsung, to TSMC. We just do not see Apple then fully transitioning its process again to Intel. However, Apple could dual-source – but the problem here is that Intel’s manufacturing process and associated products (tools, masks etc.) are different to TSMC’s; hence migration of one product line to another would be costly to say the least.
The other problem facing Intel and fellow merchant wireless semi vendors is that Samsung will lose its major Foundry customer. Samsung has a few options: a) it can try to find another customer – but getting one as large as Apple is going to be very difficult, in our view; or b) Samsung can “internalise” more of its own wireless semis (ie currently Samsung’s high-end phones sport Samsung’s Exynos chip; in the future Samsung could push its own wireless semi solutions across the portfolio and even expand its portfolio to include modems and connectivity products). If this were to happen, then obviously the total addressable market for merchant wireless semi vendors would shrink further.
Buy Rating system
Current price
GBP 10.96
Absolute
Price target
GBP 13.50 20/05/2013 London Close Market cap GBP 15,125 m Reuters ARM.L Bloomberg ARM LN
Changes made in this note Rating Buy (no change) Price target GBP 13.50 (11.50) Chg 2013e 2014e 2015e
old Δ% old Δ% old Δ%
Sales 693263 2.9 818987 3.9 818987 3.9
EBIT 363614 0.5 447404 6.4 447404 6.4
EPS 22.24 0.5 27.33 6.0 34.43 4.4
Source: Berenberg estimates
Share data
Shares outstanding (m) 1,380 Enterprise value (GBP m) 14,518 Daily trading volume 4,490,310
China Inc mainly sources wireless semis from Qualcomm, MediaTek and Spreadtrum. Qualcomm’s margins have declined by 1,300bp in little over 18 months as Qualcomm tries to compete with MediaTek et al to grab China Inc (Huawei, ZTE, Lenovo and Chinese “white box” vendors) share with superior technology. The bottom line is that Intel’s product will have to have a “wow” factor for the captive vendors to want to make a switch, and even then price will still be a determining factor. In our models, we have Intel gaining 3% market share in smartphones and 10% in tablets primarily in the Windows ecosystem by 2016 and we think it will be extremely difficult for Intel to improve on this position without a major technological and price breakthrough. Our view remains that Intel should acquire Qualcomm’s QCT chip business to gain scale in this space and harvest its X86 platform. With the recent CEO change, however, we think it will be more of the same – namely tick-tock!
In our PD royalty model, we assume smartphone shipments increase from 700m in 2012 to nearly 2bn by 2016, with chip ASPs declining by 50% from $22 to $13. At the same time, ARM’s royalty rate should increase from 1.2% today for wireless to 2% as more Big.Little and v8 cores penetrate the base. Similarly, on tablets we assume a 120m-unit market in 2012 rising to 400m in 2016, with chip ASPs down to $13 from $22 today and royalty rates up to 2% from 1.2% today. Every 0.1% movement in ARM’s smartphone and tablet application processor royalty rate adds on $30m in PD royalties.
We also assume that ARM captures 25% of the embedded microcontroller market share by 2016 from 12% in 2012, as the market shifts to 32-bit processors away from 8-bit and 16-bit, and as proprietary solutions continue to be outsourced to ARM. For example, Renesas (leading global microcontroller vendor) has recently opened up a portion of its chip family to ARM. The volume in this market is sizable with over 20bn units shipped in 2012. The sensitivity here is that every 10% market share that ARM gains equates to $75m in PD royalties.
Similarly, we assume that ARM gains a 10% share in the networking segment by 2016 as its architecture gains sockets in data centres and infrastructure products. We think ARM can command a 2.5% royalty rate in this segment, with each chip having an ASP of around $30.
The biggest unknown in our model is the size of the machine-to-machine market. Third-party research suggests 68bn units will be shipped annually (Ericsson talked about 50bn+ in the 2015-20 timeframe). Assuming $1/chip and that ARM gets 5% market share and a 1% royalty, that is $35m in additional royalty revenue.
The bottom line is that we think ARM’s PD royalty revenue can hit between $1.1bn and $1.3bn in 2016 – 16% to 35% above the street. On the back of this, we think operating leverage is higher than the street is predicting – ARM already hit 50%+ margins in Q1 2013, and on our DCF (with an 8% WACC, 15-20% revenue growth for the next five years at the group level fading to 3% in 2022 and operating margins rising from the 50% level just posted to 65% on royalty revenue acceleration relative to licence revenues), we reach our new price target of £13.50.
Total assets($m) 87,095 91,759 94,635 88,011 110,998
Net Cash ($m) 28,351 32,419 33,736 25,961 50,077
Source: Berenberg Bank estimates
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Price targets and valuation
On ARM, we increase our price target to £13.5 from £11.5. Our new price target is based on a DCF model assuming a 3% terminal growth rate, an 8.1% WACC and a 65% terminal EBIT margin.
On Infineon, our price target is €6.0, based on a sum-of-the-parts valuation adjusted for an €800m settlement for Qimonda.
On Cisco, we increase our price target to $16.0 from $14.0, based on an 8x P/E multiple on our FY14 EPS of $1.97.
On Ericsson, our price target is SEK60.0, based on an 11x P/E multiple on our FY14 EPS of SEK5.26.
On TPK, our price target is TWD400, based on an 8x P/E multiple on our FY14 EPS of TWD52.10.
On Qualcomm, our price target is $50, based on a sum-of-the-parts valuation.
On Samsung, our price target is KRW1,250,000, based on a 6x P/E multiple on our FY14 EPS of KRW203.54k.
On Apple, our price target is $360, based on a 9x P/E multiple on our FY14 EPS of $39.79.
On STM, our price target is €4.0, based on a sum-of-the-parts valuation adjusted for a $400m exit of the ST-Ericsson JV.
On Juniper, our price target is $14, based on a 13x P/E multiple on our 2014 EPS estimate of $1.07.
On Alcatel-Lucent, our price target is €0.7, based on a sum-of-the-parts valuation.
On ZTE, our price target is HKD8.5, based on a sum-of-the-parts valuation.
On MediaTek, our price target is TWD210, based on a 12x P/E multiple on our FY14 EPS of TWD17.0.
On Imagination, we cut our price target to £2.5 from £3.6, based on a DCF model assuming a 3% terminal growth rate, an 8.7% WACC and a 25% terminal EBIT margin.
On Catcher, our price target is TWD115, based on an 8x P/E multiple on our FY14 EPS of TWD14.23.
On Foxconn Tech, our price target is TWD70, based on a 10x P/E multiple on our FY14 EPS of TWD6.74.
On Motorola Solutions, our price target is $40, based on an 11x P/E multiple on our 2014 EPS estimate of $3.71.
On BlackBerry, our price target is $5.00, based on a sum-of-the-parts valuation.
On Hon Hai, our price target is TWD66, based on a 10x P/E multiple on our FY14 EPS of TWD6.91.
On Foxconn International, our price target is HKD2.5, based on a sum-of-the-parts valuation.
On Nokia, our price target is €1.5, based on a sum-of-the-parts valuation.
On HTC, our price target is TWD150, based on a 13x P/E multiple on our FY14 EPS of TWD11.79.
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Please note that the use of this research report is subject to the conditions and restrictions set forth in the “General investment-related disclosures” and the “Legal disclaimer” at the end of this document.
For analyst certification and remarks regarding foreign investors and country-specific disclosures, please refer to the respective paragraph at the end of this document.
Disclosures in respect of section 34b of the German Securities Trading Act (Wertpapierhandelsgesetz – WpHG)
Company Disclosures ARM Holdings plc no disclosures Apple Inc 5 Alcatel-Lucent no disclosures Catcher Technology Co Ltd no disclosures Cisco Systems Inc no disclosures Ericsson no disclosures Foxconn International Holdings Ltd no disclosures Foxconn Technology Co Ltd no disclosures Hon Hai Precision Ind Co Ltd no disclosures HTC Corporation no disclosures Imagination Technologies Group plc no disclosures Infineon Technologies AG 5 Juniper Networks Inc no disclosures MediaTek Inc no disclosures Motorola Solutions Inc no disclosures Nokia Oyj 5 Qualcomm Inc no disclosures BlackBerry no disclosures Samsung Electronics Co Ltd no disclosures STMicroelectronics NV no disclosures TPK Holding Co Ltd no disclosures ZTE Corp no disclosures (1) Joh. Berenberg, Gossler & Co. KG (hereinafter referred to as “the Bank”) and/or its affiliate(s) was Lead
Manager or Co-Lead Manager over the previous 12 months of a public offering of this company. (2) The Bank acts as Designated Sponsor for this company. (3) Over the previous 12 months, the Bank and/or its affiliate(s) has effected an agreement with this company
for investment banking services or received compensation or a promise to pay from this company for investment banking services.
(4) The Bank and/or its affiliate(s) holds 5% or more of the share capital of this company. (5) The Bank holds a trading position in shares of this company. (6) The Bank and/or its affiliate(s) holds a net short position of 1% or more of the share capital of this
company, calculated by methods required by German law as of the last trading day of the past month. Historical price target and rating changes for ARM Holdings plc in the last 12 months (full coverage)
Date Price target - GBP Rating Initiation of coverage
29 November 12 10.00 Buy 06 January 10
05 March 13 11.50 Buy
21 May 13 13.50 Buy
Historical price target and rating changes for Apple Inc in the last 12 months (full coverage)
Date Price target - USD Rating Initiation of coverage
04 September 12 800.00 Buy 06 January 10
05 March 13 360.00 Sell
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Historical price target and rating changes for Alcatel-Lucent in the last 12 months (full coverage)
Date Price target - EUR Rating Initiation of coverage
08 June 12 1.00 Sell 06 January 10
04 September 12 0.70 Sell
Historical price target and rating changes for Catcher Technology Co Ltd in the last 12 months (full coverage)
Date Price target - TWD Rating Initiation of coverage
08 June 12 180.00 Hold 09 December 11
04 September 12 150.00 Hold
05 March 13 115.00 Sell
Historical price target and rating changes for Cisco Systems Inc in the last 12 months (full coverage)
Date Price target - USD Rating Initiation of coverage
21 May 13 16.00 Sell 07 June 10
Historical price target and rating changes for Ericsson in the last 12 months (full coverage)
Date Price target - SEK Rating Initiation of coverage
08 June 12 53.00 Sell 06 January 10
29 November 12 51.00 Sell
05 March 13 60.00 Sell
Historical price target and rating changes for Foxconn International Holdings Ltd in the last 12 months (full coverage)
Date Price target - HKD Rating Initiation of coverage
08 June 12 2.50 Sell 09 December 11
04 September 12 2.00 Sell
29 November 12 3.00 Sell
05 March 13 2.50 Sell
Historical price target and rating changes for Foxconn Technology Co Ltd in the last 12 months (full coverage)
Date Price target - TWD Rating Initiation of coverage
08 June 12 85.00 Sell 09 December 11
05 March 13 70.00 Sell
Historical price target and rating changes for Hon Hai Precision Ind Co Ltd in the last 12 months (full coverage)
Date Price target - TWD Rating Initiation of coverage
08 June 12 80.00 Hold 09 December 11
05 March 13 66.00 Sell
Historical price target and rating changes for HTC Corporation in the last 12 months (full coverage)
Date Price target - TWD Rating Initiation of coverage
08 June 12 150.00 Sell 06 January 10
Historical price target and rating changes for Imagination Technologies Group plc in the last 12 months (full coverage)
Date Price target - GBp Rating Initiation of coverage
08 June 12 400.00 Sell 20 October 11
29 November 12 360.00 Sell
21 May 13 250.00 Sell
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Historical price target and rating changes for Infineon Technologies AG in the last 12 months (full coverage)
Date Price target - EUR Rating Initiation of coverage
08 June 12 6.50 Hold 06 January 10
04 September 12 6.00 Hold
Historical price target and rating changes for Juniper Networks Inc in the last 12 months (full coverage)
Date Price target - USD Rating Initiation of coverage
08 June 12 14.00 Sell 07 June 10
Historical price target and rating changes for MediaTek Inc in the last 12 months (full coverage)
Date Price target - TWD Rating Initiation of coverage
03 September 10
Historical price target and rating changes for Motorola Solutions Inc in the last 12 months (full coverage)
Date Price target - USD Rating Initiation of coverage
08 June 12 40.00 Sell 24 January 11
Historical price target and rating changes for Nokia Oyj in the last 12 months (full coverage)
Date Price target - EUR Rating Initiation of coverage
08 June 12 1.80 Sell 06 January 10
04 September 12 1.50 Sell
Historical price target and rating changes for Qualcomm Inc in the last 12 months (full coverage)
Date Price target - USD Rating Initiation of coverage
08 June 12 50.00 Sell 03 September 10
Historical price target and rating changes for BlackBerry in the last 12 months (full coverage)
Date Price target - USD Rating Initiation of coverage
08 June 12 7.00 Sell 06 January 10
04 September 12 5.00 Sell
Historical price target and rating changes for Samsung Electronics Co Ltd in the last 12 months (full coverage)
Date Price target - KRW Rating Initiation of coverage
08 June 12 1450000.00 Buy 08 June 12
29 November 12 1650000.00 Buy
05 March 13 1250000.00 Sell
Historical price target and rating changes for STMicroelectronics NV in the last 12 months (full coverage)
Date Price target - EUR Rating Initiation of coverage
08 June 12 3.50 Sell 06 January 10
05 March 13 4.00 Sell
Historical price target and rating changes for TPK Holding Co Ltd in the last 12 months (full coverage)
Date Price target - TWD Rating Initiation of coverage
08 June 12 360.00 Sell 09 December 11
04 September 12 320.00 Sell
05 March 13 400.00 Sell
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Historical price target and rating changes for ZTE Corp in the last 12 months (full coverage)
Date Price target - HKD Rating Initiation of coverage
08 June 12 13.00 Sell 06 January 10
04 September 12 8.50 Sell
Berenberg distribution of ratings and in proportion to investment banking services
The recommendations for companies analysed by the Bank’s equity research department are either made on an absolute basis (“absolute rating system”) or relative to the sector (“relative rating system“), which is clearly stated in the financial analysis. For both absolute and relative rating system, the three-step rating key “Buy”, “Hold” and “Sell” is applied. For a detailed explanation of our rating system, please refer to our website at
http://www.berenberg.de/research.html?&L=1
NB: During periods of high market, sector or stock volatility, or in special situations, the rating system criteria as described on our website may be breached temporarily.
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General investment-related disclosures Joh. Berenberg, Gossler & Co. KG (hereinafter referred to as „the Bank“) has made every effort to carefully research all information contained in this financial analysis. The information on which the financial analysis is based has been obtained from sources which we believe to be reliable such as, for example, Thomson Reuters, Bloomberg and the relevant specialised press as well as the company which is the subject of this financial analysis. Only that part of the research note is made available to the issuer (who is the subject of this analysis) which is necessary to properly reconcile with the facts. Should this result in considerable changes a reference is made in the research note.
Opinions expressed in this financial analysis are our current opinions as of the issuing date indicated on this document. The companies analysed by the Bank are divided into two groups: those under “full coverage” (regular updates provided); and those under “screening coverage” (updates provided as and when required at irregular intervals).
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Analyst certification I, Adnaan Ahmad, hereby certify that all of the views expressed in this report accurately reflect my personal views about any and all of the subject securities or issuers discussed herein.
In addition, I hereby certify that no part of my compensation was, is, or will be, directly or indirectly related to the specific recommendations or views expressed in this research report, nor is it tied to any specific investment banking transaction performed by the Bank or its affiliates.
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Third-party research disclosures
Company Disclosures ARM Holdings plc no disclosures Apple Inc no disclosures Alcatel-Lucent no disclosures Catcher Technology Co Ltd no disclosures Cisco Systems Inc no disclosures Ericsson no disclosures Foxconn International Holdings Ltd no disclosures Foxconn Technology Co Ltd no disclosures Hon Hai Precision Ind Co Ltd no disclosures HTC Corporation no disclosures Imagination Technologies Group plc no disclosures Infineon Technologies AG no disclosures Juniper Networks Inc no disclosures MediaTek Inc no disclosures Motorola Solutions Inc no disclosures Nokia Oyj no disclosures Qualcomm Inc no disclosures BlackBerry no disclosures Samsung Electronics Co Ltd no disclosures STMicroelectronics NV no disclosures TPK Holding Co Ltd no disclosures ZTE Corp no disclosures (1) Berenberg Capital Markets LLC owned 1% or more of the outstanding shares of any class of the subject
company by the end of the prior month.* (2) Over the previous 12 months, Berenberg Capital Markets LLC has managed or co-managed any public
offering for the subject company.* (3) Berenberg Capital Markets LLC is making a market in the subject securities at the time of the report. (4) Berenberg Capital Markets LLC received compensation for investment banking services in the past 12 months,
or expects to receive such compensation in the next 3 months.* (5) There is another potential conflict of interest of the analyst or Berenberg Capital Markets LLC, of which the
analyst knows or has reason to know at the time of publication of this research report.
* For disclosures regarding affiliates of Berenberg Capital Markets LLC please refer to the ‘Disclosures in respect of section 34b of the German Securities Trading Act (Wertpapierhandelsgesetz – WpHG)’ section above.
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