Technology

---

Analyst Viewpoints Series l May 2012

Technology Disruption and opportunity in the smartphone industry

SUMMARY At Janus, our goal is to deliver alpha by taking an in-depth approach to fundamental research. We extend this commitment to our clients and partners by providing access to the insights and opinions of Janus’ seven global sector research teams via monthly analyst interviews. In this edition of Analyst Viewpoints, Janus’ Alan Bezoza discusses the smartphone market with Director of Global Equity Strategies, Adam Schor. Bezoza offers his views on how the handset industry is evolving, challenges for manufacturers and carriers, and how fundamental research is uncovering opportunities in the sector.

Q: LET’S START ON THE HANDSET SIDE OF THE INDUSTRY. WHAT ARE THE KEY FACTORS THAT AN INVESTOR SHOULD BE THINKING ABOUT WHEN LOOKING AT THE HANDSET MARKET BROADLY? Alan Bezoza: The handset market is going through a large transition. Basically, smartphones are moving from a period of innovation to penetration. For a long time, the industry went through iterations of hardware, from putting in color screens to cameras, Bluetooth and WiFi. Now, we're seeing a wave of more intelligent phones penetrating the market with the big change coming in the form of operating systems and applications. When you go to a mobile phone store and ask, ‘What kind of smartphones do you have?’ the models pretty much all look the same on the outside. There are some smaller differences in terms of screen size, resolution and processor, but for the most part, you're paying for a brand and the ecosystem of either Android, Apple or maybe Microsoft. This innovation-to-penetration changeover is causing some headaches within the handset maker space as intense competition sets in, driving down prices and profitability. Essentially, manufacturers are now innovating on top of a third-party platform and creating very low differentiation. The good news is that the penetration of smartphones is increasing as average selling prices decline, given the added affordability and consumer awareness. However, handset makers that are simply making phones for either the Android or Windows ecosystem are likely to be challenged over the next couple of years as intense competition with little differentiation puts pressure on profitability.

Alan Bezoza Equity Analyst, Technology

KEY POINTS 

Within the global handset market, smartphones are beginning to transition from a period of innovation to one of increased penetration as average selling prices decline.



In many markets, fierce competition among carriers is putting downward pressure on revenues while increased data usage is putting upward pressure on capital expenditures.



We see opportunity in handset makers that control their own ecosystem of products and services, and some tower and wireless infrastructure companies.

Samsung, for example, is competing against Huawei and other Chinese brands that care more about volume than margins as they attempt to gain scale and brand. It wouldn’t Alan Bezoza: The awareness and adoption of smartphones surprise us to see China take over from the Koreans as a dominant force in consumer electronics, much the way that have gone up as prices have come down, no question. The they did from the Japanese about 10 years ago. The problem industry is still going through a period of very fast growth— for a lot of suppliers in developed Asia, as well as in Europe roughly 25% a year over the next few years. In China, the average smartphone wholesale price is down 18% year-over- and the U.S., is that Chinese companies’ cost structure is year, while units grew 300% last year, but admittedly much of much lower. Even before Chinese carriers adopted large subsidies for smartphones, Chinese brands had roughly 20the growth was aided by increased carrier competition 25% of the total Android marketplace. With the rise of surrounding handset subsidies. Carriers in China and other Chinese manufacturers, it could be very difficult for the entire countries, such as the U.S. and U.K., have adopted a heavy subsidy program to the consumer, so some of the cost of the industry for years unless they can somehow begin to differentiate from one another. phone is being borne by the carrier. In pre-pay markets where carrier subsidies are non-existent such as Italy, Q: OVER THE NEXT FEW YEARS, DO YOU THINK THE Indonesia and Russia, smartphone growth has been more subdued as the upfront cost to the consumer is much higher. APPLE USER-EXPERIENCE WILL BE MUCH DIFFERENT FROM ANDROID? Q: HOW IS THIS IMPACTING THE GROWTH RATE OF THE INDUSTRY AND PRICING?

Regardless, some Chinese manufacturers are now coming out with $100-$150 Android phones that will help smartphones penetrate many of these pre-pay, unsubsidized markets and could drive total units well above our estimates as the affordability levels rise. And it’s not all low-end, cheap handsets that one would expect that are selling in places like China. For example, Apple’s iPhone sales in China have been running around 10-15% of Apple’s total global sales and they still have yet to sign up China Mobile, the country’s largest carrier with 650 million subscribers, as a partner. Overall, we think it’s still a growth industry in terms of units. But margins may be tougher because most of the competition by Android players is mainly on price. Apple is a different story because the company controls its own ecosystem in both hardware and software. Apple has a differentiated product with end-to-end solutions in software and hardware integrated into multiple products—whether it’s the Mac, iPad or iPhone. This allows Apple to control its own destiny more than other manufacturers. We can’t say the company will be immune forever, but if it can continue to innovate ahead of the competition, it should be able to keep going. Q: WITH ALL THIS COMPETITION, WHAT DOES IT TAKE FOR A HANDSET MAKER TO BE PROFITABLE? Alan Bezoza: We think it’s going to be a difficult environment for handset makers that don’t control their own destiny. It’s very similar to how the PC industry evolved, becoming a low margin industry where the value has been extracted by Microsoft and Intel. In handsets, value may now be accruing at the operating system level or to component suppliers like Qualcomm.

Alan Bezoza: That's the $600 billion question for Apple: can the company continue to stay ahead of the Android ecosystem? A user experience varies from person to person. The nice thing for Apple is that once consumers begin to use and ingrain themselves with Apple’s ecosystem, it's difficult to leave. And it's not just about having the iPhone. It's having the iPhone, iPad, Apple TV and a Mac. All these devices work well together through software, services like iTunes and other integrated features such as AirPlay that provide a unified experience. That's been very difficult for Google to put together as the company only provides the software and not the hardware. Android is actually a very fragmented operating system and there are many manufacturers of TVs, handsets and other devices that have to be integrated with one another. Samsung is one company that has a good end-to-end suite of products that could potentially put it all together. But it's a question I ask myself everyday: ‘how much of a lead does Apple have?’ And can that change?’ It happened in the PC space, where Apple lost early on to Microsoft in a similar scenario. It’s something we watch closely and spend a lot of time thinking about. Q: WHAT ABOUT RESEARCH IN MOTION (RIM), WHICH IS STRUGGLING. CAN THE COMPANY STILL COMPETE? Alan Bezoza: RIM was one of the early innovators in the smartphone industry with the BlackBerry. I think the struggle RIM has now is how to innovate with software, services and devices while having lost the ecosystem battle. The company had the same vertically integrated strategy as Apple, but RIM mis-executed several times and just couldn't keep up. 2

The problem is that it’s now an ecosystem battle. For example, Apple says it already has 100 million people using its iCloud service. That's 100 million people who are likely to buy another Apple when it’s time for a new phone, computer, tablet or maybe TV at some point. I think it's going to be very difficult for a company like RIM to compete with that—even if RIM does come out with a revamped product suite. Apple continues to amaze me in terms of how the company has been able to dominate the handset and computer industries with simple products that work well together and it will be interesting to see if Apple can continue innovating, pushing the industry forward with a new man at the helm. Q: WHAT KIND OF RESEARCH DO YOU DO TO UNDERSTAND THESE INDUSTRY DYNAMICS?

Another frustrating thing for Android developers is that the monetization of the platform is so much lower than that experienced on the iPhone iOS platform. The demographics of an iPhone subscriber are much higher globally than an Android user since most Android users are buying lowerpriced phones and many may wish they had an iPhone. Again, roughly 25% of all Android phones are sold in China and most of these people aren’t buying these phones for the apps. Q: MICROSOFT AND NOKIA HAVE JOINED FORCES IN SMARTPHONES. DO THEY HAVE A COMBINATION THAT COULD POTENTIALLY REPLICATE THE INTEGRATED SYSTEM THAT APPLE HAS?

Alan Bezoza: I would never discount Microsoft given its scale, cash balance and brand recognition. It’s an important market for the company, but the question is whether Microsoft is simply too late. The thing that concerns me is Microsoft’s business model. It’s predicated on using its operating system to extract value from the manufacturer—the $10 or $15 per device that Microsoft gets, versus Android, which is free to handset makers. That $10 or $15 is pure profit on thin margin hardware, which is difficult for We also spend a lot of time talking to developers—whether manufacturers to choose to give up. So if I'm a manufacturer it’s two people in a garage in Silicon Valley or a large game I'd much rather work with Android given there is no added developer in France. It’s still very difficult for companies to ‘Microsoft tax.’ However, Microsoft is paying a lot of attention develop products and applications on different platforms, to manufacturers and application developers to make sure even more so for those with graphically intensive applications Microsoft isn’t denied access to this market. For example, the such as games. With Android, there are many manufacturers company is paying developers to create apps for its platform with different screen sizes, resolutions and processing power and Nokia to manufacture devices. But it's not clear to me on their devices that all work differently as one runs an that Microsoft will be a winner in this area. app. Sometimes, companies simply have to develop apps to the lowest common denominator, which is never the best Q: WHAT'S THE LOGIC BEHIND GOOGLE’S PURCHASE answer. In addition, there are many different operating OF MOTOROLA MOBILITY? system versions within Android that are still floating around. They name their versions by desserts in alphabetical order, Alan Bezoza: Some people have really scratched their so we’ve had Froyo, Gingerbread, Honeycomb, Ice Cream heads on the acquisition. Android has had a lot of patent issues with companies like Apple, Nokia, Samsung and Sandwich and they are now working on Jelly Bean. others going after Google for patent violations. What Google The current installed base of Android is a mess in terms of did was spend $12.5 billion on Motorola, which has a lot of how many different operating systems are being supported. patents in wireless communications and clearly that's a big Again, the problem for developers is that they will have to number for patent protection. The question is, what does build to the lowest common denominator, which means they Google do with the asset other than patent protection? And don’t always build to the current version of the software. They how can Google convince other Android manufacturers that build games and applications that work on older versions, they will be on the same playing field as Motorola in terms of screen sizes and processing powers. Moreover, it’s very access to new versions of the software? challenging to create a graphically intensive application that works on a low cost Android phone. With the amount of unit What Google is saying now is, ‘Don’t worry, we promise to share that Android has, people will develop for the platform, have a firewall between Motorola handset engineers and no doubt, but developers are growing increasingly more Android software engineers.’ But if you're Samsung, for example, you have to wonder, at some point does that frustrated as the number of differing devices proliferate. change? Alan Bezoza: We spend a lot of time trying to get a better understanding of the ecosystem. We do research on the carriers, which are the gatekeepers and an important part of the ecosystem. A key is understanding not just how they subsidize the phones, but how they think of the platform: how important is it for them to continue to support Apple or other manufacturers that may help diversify their customer base?

3

Does Google decide it wants to vertically integrate hardware and software and extract a large margin by doing so, similar to Apple? Right now, Google needs to play nice with other manufacturers, but the company also has to play nice with Motorola to make sure it’s not hindered by being part of Google. Samsung, HTC and other manufacturers that rely on Android have to be worried. Q: HOW DOES THE GROWTH OF THE SMARTPHONE MARKET IMPACT THE CARRIERS? Alan Bezoza: For carriers, it's positive because they’re seeing demand for data services grow that adds new revenue streams. However, it creates challenges because people are using less voice and SMS services, which are their bread and butter with very high margins. For example, there are lots of third-party applications that people can use to make phone calls and/or text messages for free over the data network. That has strong negative implications for the carriers since voice and SMS are high margin and this trend is difficult to stop. So it’s a double-edged sword. Additionally, the requirements on capital expenditures are much higher for data, so all this smartphone growth is putting pressure on network capacity. Another way to think of it is that voice and SMS do not use a lot of bandwidth, so the free cash flow of those services are very high. Data, on the other hand, uses more bandwidth per dollar of revenue. That's a big challenge for the industry. In most markets, there are four or five carriers competing on nothing but price, which is putting downward pressure on revenue and profitability while putting upward pressure on capital expenditures as networks become strained. That doesn't make for a healthy industry. The good news is that many carriers are under-levered given their cash flows and are not in jeopardy of financial collapse, so that’s encouraging. Q: IS THERE ANY WAY TO ALLEVIATE SOME OF THIS PRICING PRESSURE? Alan Bezoza: The carriers can be healthy companies if they can continue to increase the price of data services. The utility of the Internet or even a wireless service in your home is very important to most people. Not having Internet in your house is probably worse than not having air conditioning on a hot day. We think the industry is mispricing this value of the service to the consumer. However, the competitive intensity for data services may be much lower going forward as carriers won’t have the capacity to be too price aggressive. In voice and SMS, there is almost no price floor since those services don’t use a lot of bandwidth and they had a large margin umbrella they were able to exploit.

On a regional basis, the U.S. is a healthy market for carriers because two players have a majority of market share and the smaller carriers don’t have the financial capacity to deploy strong end-to-end national coverage, nor upgrade their networks. In addition, the country’s topology and the large suburban demographic makes it much more difficult to serve versus other countries where people live closer together. We’re seeing the same thing in China, where there are three players fighting over a market with over 1 billion people, but providing good coverage and capacity will make it difficult for a smaller new player to emerge. But in other countries, there is usually one operator in every market that becomes aggressive on pricing to gain share and ruins it for everybody. In the U.K., for example, there are five carriers serving some 50 million people. Israel is another country with only a couple million people and there are multiple carriers fighting over share—it just doesn't make economic sense. Q: WHAT’S THE IMPACT OF THESE TRENDS FOR TELECOM INFRASTRUCTURE COMPANIES? Alan Bezoza: There will be upward pressure on infrastructure capital spending by carriers due to the increasing penetration of smartphones and tablets driving traffic growth. For equipment vendors, there has been a high degree of competitive intensity, but some of those pressures are now declining and can be a powerful, welcomed change. The industry has consolidated, with Motorola Network Solutions having been bought by Nokia Siemens, and some of Nortel has been sold off in parts to Ericsson and Alcatel Lucent. It’s now becoming a two player wireless market between Ericsson and Huawei, the two share leaders with 40% and 20% of the market, respectively. In addition, Alcatel Lucent and Nokia Siemens have each been going through significant financial stress over the past few years. This is causing carrier customers to be somewhat reluctant to purchase gear from these companies as this gear can sit in a carrier’s networks for up to 8-10 years. The net result for infrastructure players is that the industry is becoming much more rational and the potential for declining competitive intensity can have a powerful effect. One area of opportunity is the wireless tower space. Most telecommunications companies have realized that it’s not economical to own their own tower infrastructure. Companies are realizing that it's more economical to rent tower space for their antennas and infrastructure. We think this is an interesting area of sustainable growth with business models that are defensible for many years.

4

Tower companies are benefiting from the same traffic growth as the equipment vendors as they build new towers and hang new antennas on existing ones. In addition, tower companies should see incremental opportunities as carriers move to next-generation 4G networks. Q: SMARTPHONE PENETRATION HAS AFFECTED BUSINESSES IN MANY WAYS. CAN YOU TALK ABOUT SOME OF THE DISRUPTIVE IMPACTS? Alan Bezoza: The smartphone has really changed consumer behavior. It has impacted retailers a lot: consumers now walk the aisles and check Internet prices on their phones in real time. In fact, I often walk into a store and end up buying the product through an online retailer that I access on my phone if I can get a better price that way. User feedback is another area that’s having a big impact on restaurants. When I'm traveling in California I can quickly look at a restaurant’s reviews and customer feedback through Yelp or make a reservation through OpenTable. Companies now really check to make sure they have the right brand recognition and quality control because consumers have become much more empowered with a computer in their pockets that is always connected and always on. The next step is mobile payments. I was in San Francisco visiting some companies and on the way to and from the airport I paid my cab fare by my phone through a service the cab driver used called Square. The company sells a device that turns your phone into a credit card reader, so I was able to pay the driver directly through his smartphone. We'll see if this becomes more pervasive. I think smartphones will eventually take over other types of computer electronics as more things are embedded in the device and more applications are developed. ******************************************************************** See following page for important disclosures.

5

ABOUT THE FEATURED ANALYST Alan Bezoza Alan Bezoza is an equity research analyst, primarily focusing on the technology sector with a specific emphasis on communications technology. He also serves as sector team leader of the technology team. Prior to joining Janus as a research analyst in July 2007, Mr. Bezoza was Senior Vice President, Equity Research at Oppenheimer & Co., where he focused on communications and media technology. Previously, he worked at Friedman, Billings, Ramsey as Senior Vice President, Equity Research focusing primarily on the cable services and digital media technology industries. Mr. Bezoza also worked at CIBC World Markets serving in the equity research group as an associate, director and finally executive director covering communications technology and cable services. He started his investment career at Lazard Asset Management where he was a portfolio analyst for the Emerging Markets and International Small Cap funds. He received his bachelor of science degree in finance from Lehigh University. Mr. Bezoza has 15 years of financial industry experience.

This publication is for investors and investment consultants interested in the institutional products and services available through Janus Capital Management LLC and its affiliates. Various account minimums or other eligibility qualifications apply depending on the investment strategy or vehicle. The views expressed are those of the author as of August 2011. They do not necessarily reflect the views of other Janus portfolio managers or other persons in Janus’ organisation. These views are subject to change at any time based on market and other conditions, and Janus disclaims any responsibility to update such views. No forecasts can be guaranteed. These views may not be relied upon as investment advice or as an indication of trading intent on behalf of any Janus portfolio. Janus makes no representation as to whether any illustration/example mentioned in this document is now or was ever held in any Janus portfolio. Illustrations are only for the limited purpose of analysing general market or economic conditions and demonstrating the Janus research process. They are not recommendations to buy or sell a security, or an indication of holdings. Issued in Europe by Janus Capital International Limited, authorised and regulated by the Financial Services Authority. Issued and distributed in: (a) Taiwan R.O.C by Janus Capital International Limited, authorised and regulated by the Financial Services Authority of the United Kingdom; (b) Hong Kong and Australia by Janus Capital Asia Limited (ARBN 122 997 317), which is incorporated in Hong Kong, is exempt from the requirement to hold an Australian financial services licence and is licensed and regulated by the Securities and Futures Commission of Hong Kong under Hong Kong laws which differ from Australian laws. In Australia, for wholesale client use only; In Taiwan R.O.C and the PRC, only available to select targeted institutional investors. This document does not constitute investment advice or an offer to sell, buy or a recommendation for securities, other than pursuant to an agreement in compliance with applicable laws, rules and regulations. Janus Capital Group and its subsidiaries are not responsible for any unlawful distribution of this document to any third parties, in whole or in part, or for information reconstructed from this presentation and do not guarantee that the information supplied is accurate, complete, or timely, or make any warranties with regards to the results obtained from its use. As with all investments, there are inherent risks that each individual should address. The distribution of this document or the information contained in it may be restricted by law and may not be used in any jurisdiction or any circumstances in which its use would be unlawful. Should the intermediary wish to pass on this document or the information contained in it to any third party, it is the responsibility of the intermediary to investigate the extent to which this is permissible under relevant law, and to comply with all such law. The opinions are those of the authors are subject to change at any time due to changes in market or economic conditions. The comments should not be construed as a recommendation of individual holdings or market sectors, but as an illustration of broader themes. Statements in the brief that reflect projections or expectations of future financial or economic performance of a strategy, or of markets in general, and statements of any Janus strategies’ plans and objectives for future operations are forward-looking statements. Actual results or events may differ materially from those projected, estimated, assumed or anticipated in any such forward-looking statement. Important factors that could result in such differences, in addition to the other factors noted with forward-looking statements, include general economic conditions such as inflation, recession and interest rates. For authorised persons only For Institutional use only. KB-0512(35)0812 EAPM Inst

6