4Q11 Earnings Update: Plenty of Runway for Cloud Leaders

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Paul Sagawa / Artur Pylak

203.901.1633 / 203.901.1634

sagawa@ / apylak@ssrllc.com

March 5, 2012

4Q11 Earnings Update: Plenty of Runway for Cloud Leaders

  • 4Q11 results revealed continued strong growth for TMT companies that we believe are poised to lead a comprehensively disruptive shift to the cloud that could open hundreds of billions of dollars in new opportunity. Nonetheless, valuation for these companies and for TMT in general remains starkly weak compared to the broader market, a reflection that investors anticipate sharp reductions in growth, profitability or both. We believe that this is a worst case scenario with no obvious catalysts, and remain comfortable recommending an overweight position in the sector and in these types of stocks in particular. We are making no changes to our large cap model portfolio and changing two companies that have been acquired and two others that seem to have lost competitive traction in our small cap model portfolio.
  • The past three months have rewarded risk, as the high-beta TMT sector outperformed the market and small caps outperformed large caps. Since December 1, large cap TMT stocks have outperformed the S&P500 by 400bp, appreciating 14.1% on average. Within that, the best returns were seen in contract manufacturing, consumer electronics and hardware, areas with betas at or above the sector average. Small cap TMT also performed well, with tech components of the S&P600 up 9.6%, about on par with the broader benchmark.
  • Yet P/E ratios for the biggest TMT companies are only slightly above other top 50 stocks despite significantly higher sales growth, net margins and cash as a percentage of cap. Excluding Amazon and its anomalous 147 P/E, the average multiple for the 13 TMT components of the top 50 US stocks by market cap is about 13.5 times, just a half point ahead of the rest of the list, despite average cash and investments equaling 18% of market cap, vs. 12% for non-financial firms.  At the same time, the average 5yr sales CAGR for the 14 TMT stocks has been 16%, vs. just 6% for the rest, and the average net margin was 16.4%, 230bp above the rest.
  • We believe that the TMT sector has begun a paradigm shift to the cloud that will disproportionately benefit a concentrated set of well positioned leaders. This architecture sea change will favor portable, wireless, cloud-based platforms and services, to the detriment of traditional PCs, the enterprise data center, fixed networks and multi-channel broadcasting. In this, we expect value in TMT to concentrate to the leaders of the new paradigm, even as TMT siphons value from the rest of the economy.
  • Cloud platform leaders are delivering extraordinary growth, profitability or both, but low multiples for most suggest expectations for sharp deterioration in earnings trajectory. The leaders of this tectonic plate shift are well represented in our large and small cap model portfolios, both of which have performed well relative to the broader market, with 11.2% and 17.7% appreciation since 12/1/11, respectively. In particular, we see Amazon, Apple, Google, and Microsoft (and soon to IPO Facebook) as central to our long-term growth thesis. These companies have averaged 29% growth over the past 5 years and delivered net margins of more than 21% in 2011, vs. 7% growth and 14% margins for the biggest non-TMT stocks. Amazon carries an outsized 147 P/E, anticipating, expansion of its 1% net margins, but the other three trade at a discount to both TMT and the broader market, despite cash and investments of more than 20% of market cap. Investors are anticipating a sharp sales deceleration, a significant margin contraction, or both.
  • We believe many investors are underestimating opportunity and overestimating risk, and advocate focus on players well positioned for the shift to the cloud. The cloud may be a better than $1T opportunity as it takes value from the huge global spending on retail, advertising, media and transactions. The growth of the market for elements of the transition – smartphones, tablets, 4G wireless service, internet video streaming and advertising, Software-as-a-Service, etc. – have been strong enough for long enough to establish a firm trajectory for change. We have reflected our conviction in this paradigm shift in the composition of our model portfolios, which comprise representative stocks that we believe are poised to exploit this change, including those companies that we believe are at its core.
  • We are maintaining our large cap portfolio as is and making small adjustments to the small cap portfolio, as both performed well in the quarter. We believe that our large and small cap portfolios are well composed to address the changes happening in the TMT landscape. As such, we are making no changes to our large cap selections. In the small cap portfolio, two stocks have been acquired (Bluecoat, Interclick) and two others appear to have lost competitive position (Comtech, Omnivision). All four are being replaced, as we add Allot, Constant Contact, Ultratech and Super Micro Computer.

I Get No Respect, I Tell Ya

Since our last portfolio update on December 1, TMT stocks have gained a bit of traction, with the universe of large cap TMT outperforming the broader index by about 200bp, up 12.1% for the three months (Exhibit 1). This move appear largely driven by improving overall market sentiment rewarding the higher beta TMT sector and the higher growth of these stocks, as relative multiples remained fairly stagnant over the quarter. The beta play also benefited small cap stocks in general, with the S&P 600 and the universe of TMT small caps growing 9.6% (Exhibit 2). Despite the valuation gap that persists between TMT and the rest of the market, we remain bullish that TMT will see multiple expansion to reward its growth in future quarters.

Exh 1: Relative Performance Summary of Large Cap Tech Stocks by Category

Exh 2: Relative Performance Summary of Small Cap Tech Stocks by Category

The persistent caution around TMT that has plagued the sector since the market crisis in 2008 and that has brought tech valuations to historical relative lows is evident in the stocks with the largest capitalization. Apple recently surpassed ExxonMobil to become the most highly valued company in the world and the sixth company to join the $500B club (Exhibit 3). Hitting that arbitrary milestone yielded a predictable flurry of cautionary articles, but unlike Cisco, Intel, and Microsoft, which passed the bar back in the go-go Internet era based on stratospheric multiples on aggressive forecast earnings, Apple sports a modest 12.6 forward multiple for 0.6 PEG ratio buttressed by cash and investments equal to about 20% of its capitalization.

The rest of the 13 TMT stocks within the 50 most highly capitalized companies share the same valuation discount, with the exception of Amazon and its 147x forward P/E. Absent Amazon, the biggest TMT companies sport a 13.5x average P/E, slightly higher than the 13.0x average P/E of the remaining stocks despite 50% faster revenue growth over the past year, and 100% faster, on average, over the past 5. This growth has not sapped profitability either, as the TMT names are delivering net profit margins 230bp higher than the others (Exhibit 4). Moreover, these stocks, on average, hold cash and investments equal to about 18% of their market capitalization vs. just 12% for non-financial stocks in the top 50. The picture suggests that investors expect TMT growth to slow dramatically, for margins to contract sharply, or both.

Exh 3: Select Financial Characteristics of the Top 50 US Listed Companies by Market Cap

Exh 4: Top 50 US Stocks – Margin, Growth, and Relative P/E

The Revolution Will Televise Itself

We have written extensively about the tectonic plate shifts that we believe will entirely remake the TMT sector with considerable effect on the rest of the economy. These changes, detailed in our recent published notes on the consumer and enterprise cloud (links) have been catalyzed by contemporaneous innovations in portable platforms, wireless networks, content delivery networks, distributed public data centers and cloud-based software services. The consumer technology market, where smartphones, tablets, wireless and the cloud have already won the day, is in the midst of a massive concentration of value into the hands of a small number of platform ecosystems that we believe will dominate on-line activity and absorb swaths of value from traditional markets like advertising, retail, financial transactions and media. The leaders of these platform ecosystems – Apple, Amazon, Facebook, Google and Microsoft – will compete sharply against each other, but in a favorable market of tremendous opportunity and sticky customers, to the detriment of companies not well positioned against the opportunities or not favorably aligned with the emerging camps.

In the enterprise market, a similar, although not so tightly concentrated, picture is emerging on the horizon. We believe the current paradigm of PC desktops and virtualized enterprise datacenters will give way to thin devices and public cloud-based applications (Exhibit 5). While the transition will be very long and very slow, the impact on the marginal dollar of IT spending will be considerable and closer in than many imagine. We believe the Windows/x86 model will give way to a heterogenous architecture for increasingly portable enterprise devices, opening the door for Apple, Android and ARM based platforms. Datacenter spending will shift from within the enterprise, where IT departments depend on premium products and turnkey solutions from trusted suppliers, to the big internet hosts, like Amazon, IBM, Microsoft and Google, which have no need for handholding or anything but barebones boxes. The result will be a dramatic commoditization of servers, storage and switching that will hit prices, margins and market shares for the leaders in all of these fields. Software vendors will suffer as well, as applications and infrastructure based on cheap open-source licenses and supported by the IT powerhouses that play host begin to crowd out traditional software.

Exh 5: Gartner PC Market Forecast Revisions, Q4 2010-Q4 2011

Ye of Little Faith

Our view of the TMT landscape is less outré than it once was, although many still balk at the stark implications for traditional media, traditional device architectures and traditional IT. The evidence for much of it seems apparent. Apple, Amazon, Google and Microsoft collectively grew revenues by more than 36% in 2011, led by Apple’s stunning 67% growth, all of it an acceleration off of the 5 year average growth for the four of 29%. In contrast, the 37 non-tech constituents of the top 50 companies grew revenues by just 11.5% on average in 2011, including blow-out numbers from the obviously cyclical energy sector, and a 5 year CAGR of just 7%.

Of the leaders, Amazon carries a seriously premium P/E of 147, largely because the company chooses to run on whisper thin margins as it pursues its e-tail manifest destiny. Longstanding experience with brick-and-mortar retail stocks have trained investors to understand long-term operating leverage when they see it and tolerate apparent management indifference to near term profitability, at least for the time being. The other three public leaders -Apple, Google and Microsoft -trade at an average 13x multiple, despite their growth, profitability and massive cash holdings. Apparently, our perspective is not as embedded in consensus as it might seem.

It would seem that investors must be anticipating a sharp deceleration in growth for TMT in general, and from the platform leaders in particular. Or perhaps, they are anticipating a dramatic contraction in margins resulting from some yet unseen price competition across the TMT board. Or maybe, both. We see no evidence of any of this, nor do we believe the market conditions make it a likely scenario. As such, we are content to ride the wave of growth and wait patiently for the multiple re-expansion that we believe is likely.

Exh 5: Sector & Sovereign Large Cap TMT Model Portfolio Performance

Large Cap Portfolio Changes

We are content to hold our 15 stock large cap model portfolio static for the quarter (Exhibit 5). Performance since December 1 has been good, up 150bp vs. the S&P, and more importantly, we believe that the stocks contained within are unusually well stationed to capitalize on the changes that we see unfolding in the TMT landscape. A handful of the stocks disappointed for their 4Q11 results, and as such, were poor performers for the portfolio, but we do not see evidence that these misses represent more than short-term hiccups. On our bubble charts of sales growth, P/E and free cash flow yield, all of these stocks – Amazon, Google, ARM, SanDisk and Nvidia – continue to show as relatively attractive, with Amazon’s lofty P/E the only red flag.

Exh 6: Sector & Sovereign Small Cap TMT Model Portfolio Performance Original Constituents Before 3/2/2012 Revision

Small Cap Portfolio Changes

We are making more changes to the small cap portfolio (Exhibit 6 and 7). Two companies were acquired during the quarter – Bluecoat by private equity and Interclick by Yahoo. Two others have been naggingly weak performers. Comtech, which provides satellite uplinks and wireless backhaul systems, has suffered from a sluggish carrier spending trajectory that is a product of price competition and customer oligopoly. Despite belief that additional 4G networks will be built, the timing is beyond the immediate investible horizon. Omnivision had been one of two major image sensor component vendors to the smartphone field with an enviable seat within Apple’s iPhone 4. Unfortunately, the 4s launched with a Sony sensor, with signs of imminent market entry of other major component vendors to the sensor space. The stock has recently rallied on rumors that it may have won a position in the coming iPad 3, but we are inclined to cut our losses here.

Exh 7: Sector & Sovereign Small Cap TMT Model Portfolio Performance Constituents after 3/2/2012 Revision

In their place, we are adding 4 new stocks. In the CDN architecture area, we are adding two names: Allot Communications, which provides equipment and software to manage and optimize carrier IP networks, and Super Micro Computer, which sells low cost, open standard servers that should be positioned to gain with further commoditization of the data center market. In on-line advertising, we are adding e-mail advertising leader Constant Contact. Finally, we believe that the growing portable device market will drive process investment by semiconductor manufacturers, and as such, we are adding semiconductor capital equipment maker Ultratech.

Additional Exhibits

Exh 8: Earnings Summary of Top 180 Large Cap TMT Companies for Fiscal Quarters ending November 2011 through January 2012

Exh 9: Sales Growth versus P/E; Large Cap Companies rated 10 in Positioning for Growth

Exh 10: Sales Growth versus P/E; Large Cap Companies rated 9 in Positioning for Growth

Exh 11: Sales Growth versus P/E; Large Cap Companies rated 8 in Positioning for Growth

Exh 12: Sales Growth versus P/E; Companies rated 7 in Positioning for Growth

Exh 13: Small Cap Tech Growth Categories: Sales Growth versus Forward Earnings

Exh 14: Energy Conservation: Sales Growth versus Forward Earnings

Exh 15: 4G Wireless: Sales Growth versus Forward Earnings

Exh 16: CDN Architecture: Sales Growth versus Forward Earnings

Exh 17: Cloud Computing: Sales Growth versus Forward Earnings
Quadrant I: (P/E < 20; Sales Growth > 20%)

Exh 18: Cloud Computing: Sales Growth versus Forward Earnings
Quadrant II: (P/E > 20; Sales Growth > 20%)

Exh 19: Cloud Computing: Sales Growth versus Forward Earnings
Quadrant III: (P/E < 20; Sales Growth < 20%)

Exh 20: Cloud Computing: Sales Growth versus Forward Earnings
Quadrant IV: (P/E > 20 ; Sales Growth < 20%)

Exh 21: Media Streaming: Sales Growth versus Forward Earnings

Exh 22: Online/Mobile Advertising: Sales Growth versus Forward Earnings

Exh 23: Smart Portable Devices: Sales Growth versus Forward Earnings

Appendix: The Large Cap TMT Universe

Appendix: The Large Cap TMT Universe (Cont.)

Appendix: The Large Cap TMT Universe (Cont.)

Appendix: The Small Cap TMT Universe

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