This is an extract from a report by Arete Research, a Telco 2.0TM partner specalising in investment analysis. The views in this article are not intended to constitute investment advice from Telco 2.0TM or STL Partners. We are reprinting Arete’s analysis to give our customers some additional insight into how some investors see the Telecoms market.
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A New IPR Cold War Begins
Everyone in the technology industry loves “next gen” products: they solve all the problems of the previous iteration! In LTE: Late, Tempting, and Elusive in June ’09, we [Arete Research] forecast delays and said LTE would require intensive R&D and bring minimal near-term sales. Two years later, its impact is limited, mostly driven by market-specific reasons. Now we see operators adopting LTE by moving to single RAN (radio access network) platforms, giving them a choice of how to use spectrum, and sparking de facto concentration of vendor market shares.
The “single RAN” (including LTE) is another example of deflation in wireless infrastructure; peak shipments of HSPA may be five years off, but now come with LTE. Collapsing networks onto single platforms (so-called “network modernisation”) prepares operators to re-farm spectrum, even if short-term spend goes up. The vendor market is consolidating around Ericsson and Huawei (both financially stable), with ZTE and Samsung as new entrants, and ALU, NSN and NEC struggling to make profits (see Fig. 1) while “pioneering” new concepts. All vendors see LTE as their chance to gain share, a dangerous phase. LTE also threatens to add costs in ’12 as networks need optimisation. A recent LTE Asia conference reinforced our three previous meanings for this nascent technology:
Still Late. In ’09 we said “Late is Great,” with no business case for aggressive deployment. Most operators are in “commercial trials”, awaiting firmer spectrum allocations, if not also devices. LTE rollouts have been admirably measured in all but a few markets, and where accelerated, mostly done for market-specific reasons.
Less Tempting? Operators are re-setting pricing and ending unlimited plans. LTE’s better spectral efficiency requires much higher device penetration. Operators are gradually deploying LTE as part of a evolution to single RAN networks (allowing re-farming), but few talk of “enabling new business models” beyond 3G technology.
Elusive Economics. As a new air interface, LTE needs work in spectrum, standards and handsets. Device makers are cagey about ramping LTE volumes at mid-range price points. Vendors are still testing new concepts to lower costs in dense urban areas. Network economics (of any G) are driven by single RAN rollouts, often by low-cost vendors.
Transformation Hardly Happens. For all the US 4G hype, LTE is continuing a decade-old “revolution” in mobile data (DoCoMo launched 3G in ’01), boosted by smartphones since ’07. LTE or not, operators struggle to add value beyond connectivity. Investors should reward operators that reach the lowest long-term cash costs, even with upfront capex.
No Help to Vendor Margins. Despite 175 “commitments” to launch LTE, single RANs will be no bonanza, inviting fresh attempts to “buy” share. In a market we see growing ~5-10% in ’12. Ericsson and Huawei are the only vendors now generating returns above their capital costs: LTE will not make this better, while vendors like NSN and ALU must fend off aggressive new entrants like ZTE pricing low to win swaps deals.
Figure 1: Vendor “Pro-Forma” Margins ’07-’12E: Only Two Make Likely Cost of Capital
To read the Briefing in full, including in addition to the above analysis of:
Operators: Better Late than Early!
Something New Here?
Standards/Spectrum: Much to Do
Vendors: Challenges ‘Aplenty
… Not Enough Profits for All
Devices: All to Come
…and the following charts and tables…
Figure 1: Vendor “Pro-Forma” Margins ’07-’12E: Only Two Make Likely Cost of Capital
Figure 2: Verizon LTE Just in the Dots
Figure 3: Terminals Needed to Make LTE Work
Figure 4: “Scissor Effect” Facing Operators
Figure 5: Every Bit of the Air: Potential Spectrum to Be Used for LTE
Figure 6: Vendor Scale on ’11 Sales: Clear Gaps
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Summary: ‘Hyper-competition’ in the mobile handset market, particularly in ‘smartphones’, will drive growth in 2010, but also emaciate profits for the majority of manufacturers. Predicted winners, losers and other market consequences.
This is a Guest Note from Arete Research, a Telco 2.0™ partner specialising in investment analysis.Members can download a PDF of this Note here.
The views in this article are not intended to constitute investment advice from Telco 2.0™ or STL Partners. We are reprinting Arete’s Analysis to give our customers some additional insight into how some Investors see the Telecoms Market.
Handsets: Demolition Derby
Arete’s last annual look at global handset markets (Handsets: Wipe-Out!, Oct. ’08) predicted every vendor would see margins fall by ~500bps. This happened: overall industry profitability dropped, as did industry sales. Now everyone is revving their engines with vastly improved product portfolios for 2010. Even with 15% unit and sales growth in ’10, we see the industry entering a phase of desperate “hyper-competition.” Smartphone vendors (Apple, RIMM, Palm, HTC) should grab $15bn of the $23bn increase in industry sales.
Longer term, the handset space is evolving into a split between partly commoditised hardware and high margin software and services. Managements face a classic moral hazard problem, incentivised to gain share rather than preserve capital. Each vendor sees 2010 as “their year.” Individually rational strategies are collectively insane: the question is who has deep enough pockets to keep their vehicles in one piece. Revving the Engines. Every vendor is making huge technology leaps in 2010: high end devices will have 64/128GBs of NAND, 8-12Mpx cameras, OLED nHD capacitive touch displays, and more features than consumers can use. Smartphones should rise 50% to 304m units (while feature phones drop 21% in units). As chipmakers support sub-$200 complete device solutions, we see a race to the bottom in smartphone pricing.
Software Smash-Up. The rush of OEMs into Android will bring differentiation issues (as Symbian faced). Beyond Apple, every software platform faces serious issues, while operators will use “open” platforms to develop their own UIs (360, OPhone, myFaves, etc.). Rising software costs will force some OEMs to adopt a PC-ODM business model, while higher-margin models of RIM and Nokia are most at risk.
Finally, the Asian Invasion. Samsung, HTC and LGE now have 30% ’09E share, with ZTE, Huawei, MTEK customers and PC ODMs all joining the fray. All seek 20%+ growth. Motorola and SonyEricsson are being forced to shrink footprint, and shift risk to ODM partners. Nokia already has an Asian cost base, but lacks new high-end devices outside its emerging markets franchise. Apple looks set to claim 40% of industry profits in ’10, as other OEMs fight a brutal war of attrition, egged on by buoyant demand for fresh products at record low prices.
Forget Defensive Driving
Our thesis for 2010 is as follows: unit volumes will rebound with 15% growth, with highly competitive pricing to keep volumes flowing. This will be driven by highly attractive devices at previously unimaginably low prices. Industry sales will also rise 15%, by $23bn, but half of the extra sales ($11bn) will be taken by Apple. Industry margins will remain under pressure from pricing and rising BoM costs. Every traditional OEM, smartphone pure-play, and new entrant are following individually rational strategies: improve portfolios, promise the moon to operators, and price to gain share. Those that fail to secure range planning slots at leading operators will develop other channels to market. Collectively, the industry is entering a period of desperation and dangerous self-belief. There are few incentives to exercise restraint for the likes of Dell (led by ex-Motorola management), Acer (the consistent PC winner at the low-end), Huawei and ZTE (which view devices as complementary to infrastructure offerings) or Samsung (where rising device units help improve utilisation of its memory and display fabs). Motorola and SonyEricsson must promote themselves actively, just to find sustainable business models on 4% share each.
Table 2 shows industry value; adjusted for the impact of Apple, it shows a continuous 4-5% decline in ASPs (though currencies also play a role). The challenge for mainstream OEMs (Nokia, Samsung, LGE, etc.) is to win back customers now exhibiting high loyalty after switching to iPhone or Blackberry. Excluding gains by Apple and RIM, industry sales are on track to fall 13% in ’09. Apple, RIM, Palm and HTC will collectively account for $15bn of our forecast incremental $23bn in industry sales in ’10E.
Within this base, we see smartphones rising from 162m units in ’08 (13% of the total) to 304m units, or 23% of total ’10E shipments. At the same time, featurephone/mid-range units will drop by 21% in ’09 and 21% again in ’10.
Key Products for 2010
Both SonyEricsson and LGE have innovative Android models coming in 1H10, LG with distinctive designs and gesture input, and a new SonyEricsson UI and messaging method.
Nokia’s roadmap features slimmer form factors, but a range of capacitive touch models will not come until 2H10. It will update the popular 6300/6700 series with a S40 touch device in 1H10.
Samsung has its usual vast array of product, and plans for 100m touch models in ’10 underlining the extent of their form factor transition.
Motorola’s line-up will focus on operator variants, with a lead device shipping in 2Q10, but a number of operators think Motorola lacks distinctive designs and see little need for Blur.
RIM will not change its current form factor approach until 2H10, when it moves to a new software platform to enhance its traditional QWERTY base. It faces commercial challenges around activation and services fees with carrier partners.
We expect Apple to reach lower price points and also launch CDMA-based iPhones in ’10.
HTC must also reduce its costs to address mid-range prices.
Every vendor plans to widen its portfolio with several “hero” models in 2010; if anything the window to hype any single launch is narrowing.
Discussions with a wide range of operators, vendors and chipmakers about 2010 device roadmaps point to an explosion of attractive products – a few trends stand out:
Operators are now deeply engaging Chinese vendors. Huawei and ZTE have Android devices coming, while TCL and Taiwanese ODMs offer low-end devices. Chipmakers confirm Android devices will drop under $100 BoM levels by YE10. This will pressure both prices and margins. The value chain is shifting rapidly to more compute-intensive devices, with Qualcomm and others enabling Asian ODMs to be active in new PC segments with smartphone-like features (touch, Adobe Flash, 3G connectivity, etc.) in large-screen form factors, to leverage their LCD base.
All devices will become “smartphones.” Samsung and Nokia are opening up APIs for mass market phones. The smartphone tag (vs. dumb ones) will be applied to devices of all sorts, the way we formerly spoke of handsets. By the end of 2010, all devices (except basic pre-paid models) will be customisable with popular applications (e.g., search, social networking, IM, etc.) even if they lack hardware for video content (i.e., memory and codecs) or mapping (GPS chipsets). Open OS devices should rise 50% to 304m units, 23% of the total market.
Pure play smartphone vendors (RIMM, HTC, Palm) must transition business models to emulate Apple (i.e., linking devices with services and content). Launching lower-cost versions of popular models (RIMM’s 8520, HTC’s Tattoo, Palm’s Pixi) implicitly recognises how crowded the high-end ($400+) is becoming. This will get worse as Motorola and SonyEricsson seek to re-invent themselves with aspirational models, and Android devices hit mid-range prices in ’10.
We had said before that key purchase criteria (design, features, brand) were reaching parity across OEMs, splitting the market into basic “phones” (voice/camera/radio) and Internet devices. The former has room for two to three scale players: Nokia, Samsung, and a third based on a PC-OEM model using standard offerings (e.g., Qualcomm or MTEK chipsets). LG and ZTE are both seeking this position, from which SonyEricsson and Motorola retreated to focus on Internet devices. This does not mean mobile devices are now commodities, like wheat or steel. The complexity of melding software and hardware in tiny, highly functional packages is not the stuff of commodity markets. But we see a split where a narrow range of standard hardware platforms will accommodate an equally narrow set of software choices. Mediatek is blazing a trail here. Some operators (Vodafone, China Mobile, etc.) aim to follow this model for pre-paid and mid-range featurephones. Preserving software and services value-add for consumers in a market where hardware pricing is fairly transparent is a challenge for all OEMs.
This model is not confined to the low-end: In Wipe Out! we said Motorola (among others) would adopt an HTC/Dell model (integrating standard chipsets/software and cutting R&D). This is happening, with Motorola no longer trying to control its software roadmap, having fully adopted Android. SonyEricsson is following suit, with initial Android devices coming in 1Q10.
Recent management changes make it even more likely SonyEricsson gets absorbed into Sony to integrate with content (as its new marketing campaign pre-sages). Internet devices will become even more fragmented by would-be new entrants in ’10. In addition to Nokia, Apple, RIMM, HTC and Palm, LG and Samsung intend to build a presence in smartphones, as do Huawei, ZTE and PC ODMs. We had expected LGE or Samsung to consider M&A (i.e., buying HTC or Palm) to cement their scale or get a native OS platform. We forecast the shift to Internet devices would bring 27m incremental units from RIM, HTC, and Apple in ’09E. This now looks like it will be 21m units (partly due to weaker HTC sales), a growth of 58% vs. an overall market decline of 6%.
Growth: Steaming Again
After a long string of rises in both units and industry value, the global handset market retreated in ’09. We see risk of a weaker 1H10 mitigated in part by trends in China (3G) and India (competition among new operators). The industry had already scaled up for 10-20%+ growth during the ’05-’08 boom; most vendors have highly outsourced business models and/or partly idle capacity, meaning they could produce additional units relatively quickly. Paradoxically, 15% unit and sales growth will further encourage aggressive efforts to gain share.
Our regional forecasts are in Table 3. Emerging markets are two-thirds of volumes in ’09E and ’10E, and will lead growth – at ever lower price points – as they adopt 3G. Market dynamics vary sharply between highly-subsidised, contract-led markets (i.e., the US, Japan/Korea, and W. Europe) and pre-paid-led emerging markets (China, India, E. Europe, MEA and LatAm). In the former, operators are driving smartphone adoption; while price erosion helps limit subsidy budgets, we see growth in handset market value. As Table 4 shows, mobile data handsets hit 10%+ of EU operator sales, but are not yet driving operators’ sales growth.
In emerging markets, the growth in value is led by further volume increases for LCHs. In ’05, we saw an inflection point around Low-Cost Handsets: Every Penny Counts (July ’05) and A Billion Handsets in ’07? (Aug. ’05). Since ’05, there were 1.2bn handsets shipped in China and India alone. LCH chipsets now sell for <$5, with only Infineon and Mediatek actively supplying meaningful volumes. The ongoing mix shift to emerging markets and weak sales of mid-range devices in developed markets were behind the 13% decline in industry value in ’09E, excluding Apple’s sales. Of the extra 170m units we see shipping in ’10E, 105m come from emerging markets, with ~50m sold in China and India.
Costs: Relentless Slamming
In Wipe Out!, Arete laid out four areas where costs might rise in ’09 and beyond, as the source of structural pressure on industry margins. None of these costs are easing or receding. First, the chipset market is increasingly concentrating. TI is exiting, ST-Ericsson continues to lose money, Infineon recovered but still lacks scale in 3G, and Mediatek dominates outside the top five OEMs. This leaves Qualcomm in a de facto leadership position in 3G. This structure does not support meaningful cost reduction for OEMs. Intel may seek an entry to disrupt the market (see Qualcomm v Intel, Fight of the Century, Sept. ’09) but this is unlikely to happen until ’11. Memory may be in short supply in ’10, while high-end OLED displays still face shortages. Capacity cuts and losses at smaller component suppliers in ’09 limit how much OEMs can save. Outsourced manufacturers like Foxconn, Compal, Jabil, BYD, and Flextronics have low margins and poor cash flow. OEMs want to transfer more risk to suppliers that have little room to cut further.
Second, feature creep also thwarts cost reduction efforts: packing more into every phone is needed to stimulate demand, but adds cost. There are rising requirements in the mid-range, going from 2Mpx to 3.2/5Mpx camera modules, and adding touch, more memory, and multi-radio chipsets (3G, WiFi, BT, FM, etc.). Samsung already offers a 2Mpx touchscreen 2G phone for <$100 on pre-paid tariffs.
Third, software remains the fastest-rising element of handset costs. In Mobile Software Home Truths (Sept. ’09), we discussed how software was adding costs, but how many OEMs were struggling to realise value from software investments? Adopting “licence-free” or open source software does not necessarily reduce these costs: it must still be managed within industrial processes. Yet saving licence costs will be the argument used by OEMs forced to limit the number of platforms they support, as Samsung did by recently indicating it would abandon Symbian. We understand WinMo efforts have been largely mothballed at Motorola and SonyEricsson, even as LG is increasing its spend around Microsoft. Costs are also rising for integration of services, while Software costs are not falling; vendors are just shifting them from handset bill-of-materials (BoM) to other companies’ R&D budgets.
Finally, marketing costs are also rising. Vendors must provide $10m-50m per market of above-the-line marketing support and in-store promotions, to get operators to feature “hero” products. Services adds costs for integration and (often-overlooked) indirect product costs (testing, warranty, logistics, price protection in the channel). SG&A must rise to educate users about new services. OEMs cannot retain or win customers in a mature market without more marketing.
The case for services remains simple and compelling: Nokia’s 33% gross margin on €65 ASPs yields €22 gross profit per device, or €1/month over a two-year lifetime. This is the only way to offset further pressure on device profits. The drive to launch Services is another cost OEMs must bear, with a longer payback than that of 12-18 month design cycles for devices.
Margins: Beyond Fender Benders
When Motorola has lost $4bn since ’07 and SonyEricsson may lose as much as €1bn in ’09, we are no longer talking about minor dents. Gross margins for both are already low (sub-20%). The most notable feature of the past few years was how exposed some vendors were when extensions of hit products (or product families) fell flat. SonyEricsson went from 13% 4Q07 margins to breakeven by 2Q08, and RIM saw group gross margins drop 1000bps. Only Nokia (at 33%), RIM, Apple and HTC have gross margins above 30%. Few OEMs managed to raise gross margins after seeing them decline, though we see SonyEricsson and Motorola seeking to do so by vastly reducing their scope of activities.
Having an Asian low-cost base is a necessary but not sufficient condition of survival. Nokia is already the largest Asian producer, with the industry’s two largest plants (in China and India) giving it the lowest cost structure (i.e., the lowest ASPs, but consistently among the highest margins). Few OEMs other than Nokia make money selling LCHs (i.e., sub-€30). Nokia made ~60% of industry profits in ’08, but will be surpassed in profits in ’09 by Apple, which should make 40% of industry profits in ’10, while Nokia has 25%. It is also worth noting that we forecast margins to fall at nearly every vendor in ’10, though Motorola and SonyEricsson must end large losses, and Nokia will benefit for IPR income within its Devices margin.
Software: Mutual Destruction?
The mobile industry is rapidly adopting the IT industry’s software as a service (SaaS) model. The handset is becoming a distribution platform for services and content; vendors aim to monetise a “community” of their device users. Yet for all the attention it gets, software is a means to an end, and not part of the product. Beyond RIM and Apple, only Nokia can afford its own smartphone platform R&D (i.e., Symbian), yet we see Nokia itself moving closer to Microsoft. Money alone cannot solve software or services issues; if so, Nokia’s industry-leading €3bn R&D budget would have yielded more success, while Apple would not have grabbed as much profit share with a $1.3bn group-wide R&D budget.
No vendor yet excels at ease-of-use for multiple applications (voice, SMS, music, video, browsing, navigation, etc.). RIM offers best-in-class messaging, but falls short in other use cases. The iPhone’s Web experience allowed it to overcome shortcomings in multi-threading and voice/text. Samsung has few services to accompany its sleek designs or high-spec displays and cameras. Just going to 70-100m touch-screed devices in ’10 will not resolve ease-of-use issues.
A number of vendors risk getting addicted to “free” software platforms where others reap the benefits (e.g., Android). Few OEMs have embraced regular updates of components (media players, browser plug-ins, etc.) to meet changing requirements. This is Apple’s edge (and in theory Microsoft’s, but it has not managed handset software efficiently). The current slowdown will only hasten moves to abstraction of hardware and software, long the case in PCs. What is the point of OEMs having their own “developer programmes” (e.g., MOTODEV, Samsung Mobile Innovation, SonyEricsson Developer World, etc.) if they adopt Android? To escape high software costs, some vendors are adopting a PC-OEM model: sub-20% gross margins, 1-5% R&D/sales, with little control over how services are implemented on devices.
When the Dust Settles…
After turmoil and consolidation in ’06, industry margins were robust in ’07, then plunged in ’08. Yet a hoped-for recovery in ’09 has given heart to a range of weaker players, sealing the industry’s fate.
Even with a resumption of growth, rising costs and hyper competition look set to put pressure on margins. The precipitous impact of this may not be seen until 2011; for now, managements are not inclined to call it quits, or admit they lack a services or software play. The handset market is hardly gone ex-growth, but its rules and value chain are shifting, as seen in Apple and Google staking their claims.
The market looks to be falling less than the $11bn we forecast for ’09 (“only” $9bn), but it is Apple’s incremental sales that are changing the dynamics most. We are no fans of M&A, but would welcome moves to remove industry capacity. There are few obvious options, beyond HTC and Palm. We also think Samsung and LGE would benefit from deals that might open up their insular corporate cultures. Nokia has showed how difficult it is for an OEM to assemble a portfolio of Services offerings: none are yet best-in-class. Our verdicts on the key questions for vendors are listed in the following table: We see room for two to three scale players in LCHs/feature-phones (Nokia, Samsung and one other following a PC-OEM model). Smartphones will grow even more fragmented and hotly contested. We are not certain whether the others – SonyEricsson, LGE, Motorola, ZTE, HTC, and Japanese vendors – will emerge from 2010 in one piece.
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