TMT: Portfolio Update – Dreams, Comebacks, Skeptics and the Death Watch Redux

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TMT: Portfolio Update – Dreams, Comebacks, Skeptics and the Death Watch Redux

Last quarter, we created a framework to assess TMT stocks, juxtaposing near-term cash flow expectations (5-year consensus cash flows) with long term expectations (post 5 year cash flows implied by residual value). Arrayed on these axes, companies fall into 4 distinct quadrants 1) High near-term/High long-term “Dream Stocks”, 2) High/Low “Skepticism Stocks”, 3)Low/High “Comeback Stocks”, and 4) Low/Low “Death Stocks”. We extended this analysis to all US-traded TMT stocks with market cap above $3B, yielding a universe of 180 names, updating it to account for recent changes in valuation. As with the original analysis, the stocks largely fall into intuitively sensible quadrants. We believe the categorization has clear implications for investment – Dream Stocks are easily forgiven for short term transgressions, Skepticism Stocks are chronically “undervalued”, Comeback Stocks must justify their valuations or rerate, and Death Stocks have potential to surprise but could be value traps.

TMT valuations reflect expectations driven by themes. Valuation metrics have been poor predictors of TMT performance – expensive stocks often grow into their valuations, while cheap ones often get cheaper or fail. Still, in the context of a thematic investing approach, valuation can shed insight into the sentiment behind individual names. Our model sorts a universe of 180 large cap TMT stocks based on consensus 5-year cash flow projections and the percentage of enterprise value represented by the 5th year terminal value implied by the current share price, metrics intended to represent the short term and long term growth expectations of the market.

“Dream Stocks” must keep investors believing. The quadrant characterized by high growth expectations for both the short and long term as “Dream Stocks”. These are the long term leaders in the emerging cloud/mobile era – names like NFLX, FB, CRM, and WDAY reside here. Typically, investments in this category work, as long as that belief of long-term dominance remains intact. Unexpected signs of competitive rivalry or other business model deterioration are treated far more harshly than short term sales or EPS fluctuations. While these stocks are maddening to value investors, they are analogous to DELL, CSCO, MSFT, and INTC during the heyday of the PC era.

“Death Watch” stocks must overcome deep investor biases. The “Death Watch” quadrant is the group of stocks with low expectations in both the short and long term. These companies are often value traps with little prospect for reversing decelerating earnings. Today, the “Death Watch” includes PC era leaders like ORCL, NTAP, and CSCO, where we largely concur with the negative implications of their valuations. However, the “Death Watch” also includes stocks, like MSFT, STX, and WDC, where neither short term nor long term expectations reflect the real growth potential. If we are correct, these names could show significant appreciation as results belie the market bias.

Investors do not believe that “Skepticism Stocks” can sustain near term momentum. Stocks that sport strong consensus short term FCF growth, but modest terminal values reflect low investor confidence that current success can be sustained. This quadrant contains stalwarts like QCOM, VMW, GLW, and EBAY. In each case, the size of the company, the emergence of disruptive competitors, and the lack of compelling new paradigm growth narratives tempers investor enthusiasm. These stocks may continue to underperform their near term performance unless they can reestablish their growth bona fides with new product initiatives and/or substantial upside revenue surprises. Otherwise, strong results by these companies may go unrewarded, much as MSFT remained “cheap” during its post-Gates decade of slow growth and high cash flows.

“Comeback Stocks” often reflect unwarranted investor optimism. The 4th category holds stocks with dismal short term expectations but high implied long-term value. Here we find old-line IT names, like IBM, XRX, ADP and PAYX, where recovery is a substantial stretch. These stocks are amongst the most vulnerable in the TMT universe, as unless near term cash flows can surprise significantly to the upside, it is almost certain that the implicit long term expectations will have to contract.  Eventually, we expect most to be excellent candidates for short side investments.

Stocks shift quadrants on price moves, revisions and earnings. The implied long term growth changes with stock price, everything else equal, moving names up and down with sharp changes in valuation. Earnings and revisions affect the 5-year expected growth, moving a stock left when revisions are particularly negative relative to reported results and right when the opposite is true. For example, a slew of cyclical stocks moved into the Dream category on anticipatory upward revisions. AAPL lurched leftward past the Deathwatch threshold as revisions did not keep pace with strong earnings, while GOOG dropped toward Skepticism status on multiple contraction after 3Q earnings. These moves are interesting, because they may imply future revisions, highlight investor overreaction or indicate real changes in sentiment. Obviously, stocks that are close to the threshold of either axis are more likely to shift quadrants, and we note that traditional cyclical stocks shift by their nature.

Adding AAPL and TMUS to our large cap model portfolio. Performance in the large cap portfolio was flat the past 3 months, with early strength scuttled by the significant earnings season downturn in internet stocks, such as NFLX, AMZN, GOOG, TWTR, and FB, as well as poor results delivered by S and ARMH. We are concerned that AMZN is likely to see further losses and downward revisions in coming quarters, and are replacing it with AAPL, where we expect strong 1H15 results and upward revisions. We will also replace S with TMUS, based on our disappointment in S’s strategy and execution.

Adding INVN, ZEN and PFPT to our small cap model portfolio. Our small cap portfolio underperformed its benchmark, with poor performance from XXIA, AMCC, and FUEL partly offset by strong performance by CNVR and OVTI. We are replacing XXIA and AMCC, neither of which appears to be capitalizing on opportunities that we had seen for each, along with FUEL, which has become mired in controversy. We are adding INVN, a leading provider of MEMS sensors for mobile devices, ZEN, a provider of SaaS customer service applications, and PFPT, a SaaS security vendor. All three companies are well positioned for opportunities created by the ongoing paradigm shift to mobile devices and distributed cloud data centers.

For our full research notes, please visit our published research site.

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