Portfolio Update: Some More E-Commerce in Our Cart

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SEE LAST PAGE OF THIS REPORT Paul Sagawa / Tejas Raut Dessai

FOR IMPORTANT DISCLOSURES 917.747.1923 /919.360.6278

psagawa@ / trdessai@ssrllc.com

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September 10, 2020

Portfolio Update: Some More E-Commerce in Our Cart

Our pandemic investment themes – SaaS players with WFH exposure, cybersecurity, cloud infrastructure, e-commerce, and digital media – continued to show strong momentum through 2Q20, driving our 15-stock model portfolio to 15.8% absolute returns since our June update, beating the S&P500 by 625bp and the tech components of the index (our benchmark) by 238bp over those 3 months. We remain surprised that the standard deviation of stock performance for the TMT sector has only broadened by 65% since the beginning of March and expect the gap between winners and loser to widen as the recession proceeds. In this context, we advise caution in looking for value opportunities – there are additional shoes to drop for most “cheap” TMT names. In contrast, we see growth names benefitting from the pandemic and facing easily beaten expectations – many more than can fit in our model portfolio. Reviewing our current picks, we note that we are skewed toward enterprise IT, with only 3 of 15 drawing most of their revenues from consumer end markets. Given that, we are replacing AYX (a strong company with considerable further upside) with MELI, gaining non-US exposure as well as doubling our bet on e-commerce.

  • A volatile quarter. Our 15-stock model portfolio was on a roller coaster ride over the past 3 months, ending the period up 625bp vs. the S&P and the tech components of that index (our benchmark) by 238 bp, posting performance +/- 200bp on 24 separate trading sessions. While the period ends on a tech slide, we lost just 408 bp to the broader market over the past week and 108 bp vs. the benchmark. Our top performers, FSLY, ZS and NVDA were each up more than 30%, out of 9 names that appreciated more than 10%. AYX (-22%) was our only stock to decline double digits, despite handily beating consensus sales and EPS management offered sober guidance for 2H20 in light of the pandemic.
  • Our pandemic investment themes are working. SaaS stocks beat consensus sales projections by an average of 572 bp in 2Q20, delivering 27.2% YoY growth and driving 13.8% average appreciation since our last update. Those with clear benefit from the pandemic did even better, sales growing 32% and shares up 12.9%. Cloud-based cybersecurity results were also strong – average top-line and bottom-line surprises were 564 bp and 2890 bp respectively – with stock performance a bit more modest at +13.4%. Cloud infrastructure – a grab bag of IaaS platform operators, CDNs, hybrid cloud solutions, and datacenter components – had many notable winners in the quarter, including portfolio constituents MSFT (+8.2%), FSLY (+73.2%), NTNX (+11.2%), and NVDA (+33.4%). E-commerce was led by AMZN (+23.8%) which delivered a dominant quarter with gross merchandise volumes up more than 50% YoY, but almost all names in the group delivered significant upside vs. expectations. Finally, NFLX (+21.3%) is the primary pure play in digital media. It easily bested consensus with 25% top line growth and a big surprise on new subs, yet analysts are still modeling a sharp deceleration – we see opportunity.
  • Expect spread between winners and losers to broaden. The standard deviation of TMT stock performance has increased by ~65% since the start of the pandemic. This is a wider distribution than last quarter but remains quite narrow vs. both the 2001 and 2009 recessions. We believe results over the next several quarters will drive significant outperformance for companies benefitting from the pandemic vs. those that are burdened by it causing a further broadening of the distribution.
  • Few “value” names are well positioned. The list of large cap TMT stocks with forward P/Es less than 25 and P/S less than 5 is just 30 names, with traditional media, cable/telecom operators, and old-line IT suppliers predominant. In general, this group lacks catalysts to drive upside surprises or build a more positive investment narrative and we would advise caution. We do see upside for PC vendors (HPQ is in our portfolio) and we believe NTNX, which trades at 4.3x very conservative forward sales estimates but is not currently profitable (so not on the list), is on the verge of a significant reacceleration. We also see potential for an upturn in the volatile disc drive market (STX and WDC). While we have been constructive on IBM in the past, we believe that its further recovery is likely post-pandemic.
  • Our portfolio is skewed to enterprise spending. With 5 SaaS application vendors (AYX, ZEN, TEAM, PS, TWOU), 2 cloud-based cybersecurity names (OKTA, ZS), the biggest enterprise software company (MSFT), a hybrid cloud software supplier (NTNX), a PC/printer vendor (HPQ), a top supplier to hyperscale datacenters (NVDA) and the fastest growing CDN (FSLY), our portfolio is heavy with companies that primarily sell to enterprises. Even GOOGL and AMZN have important B2B elements of their businesses. Noting that performance has been strong, this may be a good call, but we see room to add further exposure to consumer tech spending.
  • Adding MELI. E-commerce companies delivered blow out results in 2Q20 almost across the board. While growth rates will inevitably cool from these pandemic-infused torrid levels, we believe online shopping has permanently shifted to a higher trajectory, with new shoppers, new categories (groceries, pharmacy, furniture, etc.) and new geographies now on board. From a list of great options (SHOP, W, ETSY, FVRR, etc.) we are adding MELI, which adds international exposure as well as e-commerce.
  • Removing AYX. We may end up regretting cutting AYX. It has a unique solution to a big problem – scrubbing sloppy databases and converting disparate data sources into common formats in preparation for big data analyses and AI training. Still, in the pandemic, spending on big data seems to have taken a back seat to supporting remote workers and protecting systems from cyberthreats. Up nearly 250% since we added it in May 2018, we will take our profits now.

Exh 1: SSR TMT 15 Stock Model Portfolio Performance Since Last Update

An E-Ticket Ride

Our model portfolio performance was caught up in a four-way tug of war amongst investors looking for bright spots in the ongoing pandemic, investors shopping for bargains ahead of the hoped-for V-shaped recovery, investors betting against high multiple stocks, and, apparently, Softbank. Riding very strong results for the 2Q20 earning season, our picks fared well, up 15.8% since the June update, 625 bp ahead of the S&P500, and 238 bp ahead of the tech components of that index (our benchmark). Still, the ride was a bumpy one, with the portfolio up or down more than 100 bp on 42 different days in the period, losing as much as 800 bp to our benchmark on one day only to gain 640 bp on another session within a week’s time.

Checking on our Themes

The pandemic has forced major changes to lives around the planet, isolating people at home, closing offices and schools, reducing enthusiasm for patronizing brick-and-mortar businesses, squelching travel, killing group events, disrupting supply chains for many products, and so on. Since February, we have focused our research on the ramifications of these changes, many of which we believe have lasting implications well beyond the term of the crisis. From this, we can identify five basic themes that are driving our portfolio

Exh 2: SSR TMT Model Portfolio Daily Absolute Returns Since Last Update

Exh 3: Model Portfolio Daily Returns Relative to Benchmarks Since Last Update

Exh 4: TMT portfolio cumulative performance relative to benchmark – QTD

Exh 5: TMT portfolio cumulative performance relative to benchmark trailing 5 Yr.

Exh 6: Top-line surprises posted by portfolio constituents in most recent quarter

Exh 7: Sales growth reported by portfolio constituents in the most recent quarter

recommendations: SaaS players with WFH exposure, cybersecurity, cloud infrastructure, e-commerce, and digital media (Exhibit 1 – 7).

SaaS Players: Generally, SaaS applications have some advantage over premises-based applications just for the cloud delivery mechanism. Enterprise IT departments are working from home and employees are accessing systems remotely via the cloud, so managing a SaaS app is just easier than maintaining software running on your private datacenter. That said, some SaaS apps – those that actually facilitate productive work from home – have more advantage than others, while more complex solutions with more involved sales processes have seen the time it takes to close deals stretching longer. We have written about this (SaaS: Opportunities and Obstacles, Who Wins?).

SaaS companies fared very well in 2Q20. Of the 75 large and mid-cap SaaS names to have reported, just one missed consensus and the group delivered an average top-line beat of 5.7%, a clear step up from previous quarters. The mean YoY growth rate for these companies was 27.2%, spurring 3967 bp of outperformance vs. the S&P500 (Exhibit 8, 9). From our portfolio, Zendesk and 2U were the best performers, up 18.5% and 9.6% respectively. Still, we believe consensus for the group, which forecasts a fairly sharp deceleration from the established trajectory, is far too pessimistic.

There are many interesting SaaS investment opportunities. Five of the fifteen stocks in our model portfolio are squarely centered in SaaS (AYX, PS, TEAM, TWOU, and ZEN), six if you add software megacap MSFT to the list, and we could easily fill the roster with other attractive SaaS stocks. CRM, WDAY and NOW were previously constituents, replaced only because we saw smaller names that we thought had more upside potential. We also have interest in TWLO, DDOG, PLAN, MDB, BILL, and COUP.

Exh 8: Avg. top-line surprises posted by SaaS stocks with >$1B market cap

Exh 9: Consensus sales growth estimates for high-growth SaaS are too pessimistic

Cybersecurity: The massive, nearly instantaneous jump in workers accessing enterprise networks from home has multiplied the threat of cybercrime many-fold. Here, like in applications, the advantaged solutions are run in the cloud, where IT employees can monitor them from home and where malicious traffic can be intercepted before it touches the enterprise’s systems. We have written of this in detail (Cybersecurity: Dumb Users and State Sponsored Cyberweapons). There are 18 public cybersecurity companies with market caps of at least $1B. Of these, 13 run primarily in the cloud. Those cloud-based names delivered sales growth of 23.4% with an upside surprise of 5.6% on average during 2Q20. Share prices rose an average of 13.4% since our last update, matching the benchmark. Our model portfolio includes Okta and ZScaler, which were up by 16% and 40% respectively. We are also enthusiastic for other cloud-based security names, such as CrowdStrike, Sail Point, Proofpoint, and Splunk (Exhibit 10).

Cloud Infrastructure: Enterprises are stepping up plans to shift their computing into the cloud. The growth of online consumer franchises – e-commerce, streaming video, social media, gaming, etc. – is also driving considerable demand for cloud infrastructure. Here we see four primary subcategories: hyperscale datacenters, CDNs, hybrid cloud tools, and components. The hyperscale datacenter market is dominated by Amazon’s AWS, Microsoft’s Azure and Alphabet’s Google Cloud Platform (GCP), although IBM seems to have established a growing niche position and regional players, like China’s Alibaba, are also substantial players. While AWS carries a substantial market share lead for commercial hosting, Azure has been gaining for a few years and has an enviable position with the traditional IT buyers that are driving most of the growth. GCP is known as an innovator and has grown MUCH more aggressive under former Oracle executive Thomas Kurian. All three parent companies are in our model portfolio (Exhibit 11, 12).

Exh 10: Snapshot of Financial and Valuation Metrics for Cybersecurity Stocks

Content Delivery Networks (CDNs) are used to greatly reduce the delays that users experience with cloud-based applications. They also represent an extra line of defense against many security threats, such as distributed denial of service attacks. Applications like streaming video and online gaming benefit greatly from CDNs, as do many SaaS applications. We recently wrote about their role ad future opportunity. (Internet Architecture: The Problem is Latency, Not Connection Speed) We added the fastest growing and most innovated CDN Fastly to the model portfolio just 3 months ago and it has already returned almost 70%. It had been trading even higher before news that the controversial Tik Tok was a 12% customer sparked a nearly 30% sell off. Given more than 60% YoY sales growth, we think the reaction was quite overdone. Cloudflare is another innovative CDN, growing more slowly than Fastly. Akamai is the old guard in CDN, losing share to the newcomers.

Increasingly, enterprises find themselves stretched between the cloud and their internal datacenters with applications and databases that bridge across both. There is an important market for tools to help IT departments cope with the disparate requirements of the hybrid environment. VMWare is the leader here, partnered with AWS and ensconced with many customers by virtue of its dominant virtualization franchise. Nutanix is the clear number two. We have Nutanix in our model portfolio, enjoying the recent 30% jump in the shares after a 2Q20 sales and earnings surprise.

Finally, all of these cloud services rely on significant investments in hardware. (Processor Diversity Coming to the Cloud) Processor suppliers Nvidia, Intel, and AMD all reported blow out sales, driven by strong datacenter demand. (Intel’s big 2Q20 upside surprise was offset by news that its transition to 7nm would be delayed) Networking chip vendor AVGO saw strong datacenter sales drive its upside surprise. Several companies, while struggling with demand in other parts of their businesses, e.g. Seagate, Western digital, Xilinx and others, noted cloud datacenter demand as a bright point. We believe capex by hyperscale operators, like AWS, Azure and GCP, will continue to trend above expectations. Nvidia was one of the best performers in our model portfolio, up 33.4% over the 3 months since our last update.

Exh 11: Snapshot of Financial and Valuation Metrics for Cloud Infra Stocks

Exh 12: FQ Sales Growth Rates for Leading Cloud Infrastructure Franchises

E-Commerce: Amazon’s blow out 2Q20 numbers – sales up 40% YoY, gross merchandise volumes up more than 50%, EPS an extraordinary 544% above consensus – were echoed across the e-commerce segment. Across 8 mid/large cap e-commerce specialists, the average upside sales surprise was a whopping 17.3%. Of course, consensus is projecting a sharp deceleration, despite two more quarters of easy compares, leaving lots of room for upward revisions and future surprises. We recently wrote about the accelerated shift toward e-commerce (Ecommerce in the time of COVID), highlighting opportunities with new shoppers, new categories (e.g. grocery, pharmacy, furniture, etc.), and new geographies, and the strong likelihood that

Exh 13: Snapshot of Financial and Valuation Metrics for E-Commerce Stocks

Exh 14: Consensus estimates for eCommerce sales are incoherent and pessimistic

demand will stay strong even as physical stores reopen. In addition to Amazon, we see upside for investors in Mercado Libre, Shopify, Etsy, Wayfair, Chewy and Fivrr (Exhibit 13, 14).

Digital Media: The pandemic is accelerating changes that had been long underway in the media sector. TV viewership had been in decline for a decade, and despite consumers at home in social isolation, the hold on live sports and in filming new programming weighed heavily on PayTV system operators and networks alike. (Future of Video) Cord cutting has accelerated, ratings are down hard, and advertisers are cutting their budgets and shifting money to online campaigns. While this is bad for traditional media, it is great for digital platforms. Streaming video numbers are up big, with Netflix and YouTube leading the way. We see the two megacap giants as sure winning bets in a business that has jumped to a new trajectory in the crisis. Amazon, Disney, and AT&T’s HBO are also likely long-term winners in streaming, although for Disney and AT&T, problems with their other businesses will overshadow any gains from their streaming platforms.

We also see the significant share gains for digital advertising as fuel for social media platforms once the economy begins to recover. Google, Facebook, Twitter, Snap, and Pinterest are all well placed for a sharp reacceleration in the wake of the crisis. Digital ad broker The Trade Desk is also positioned for major gains. Taken as a whole, large/mid-cap digital media stocks delivered solid 8% growth in the face of a global recession, surprising vs. consensus sales estimates by an average of 3.5%. We have included Alphabet and Netflix in our model portfolio and would recommend the other names that we have noted above. (Exhibit 15)

Exh 15: Snapshot of Financial and Valuation Metrics for Digital Media Stocks

Bottom Fishing Season Started Too Early

Historically, the spread between TMT winners and losers widens considerably during recessions. From 2001 to 2003, the standard deviation of quarterly returns for TMT stocks more than tripled from its previously established distribution before returning to the more typical spread. The 2008 mortgage shock saw the distribution widen again, this time the standard deviation more the doubled and stayed elevated until 2010. (TMT in Pandemic: Separation of Winners and Losers) So far this year, the standard deviation of returns in TMT is up just 65%, suggesting more room for the gap between stars and sluggards to broaden as the reality of global recession settles in (Exhibit 16 – 18).

Most of our model portfolio recommendations are obvious growth names arrayed against the pandemic-advantaged opportunities that we have reviewed. For value investors, the list of TMT companies with P/E’s below 25 and P/S’s less than 5 is a dog’s breakfast of old-line media, cable MSOs, telecom carriers, and traditional on-premises enterprise IT suppliers. Sorting through the 40 names with caps better than $10B, we see only a few interesting possibilities. Chief amongst these are the PC makers HP and Dell, both of which delivered encouraging results for 2Q20 on strong PC sales for the work-from-home market, which

Exh 16: Std. deviation of quarterly returns for S&P 500 IT components during 2000

Exh 17: Std. deviation of quarterly returns for S&P 500 during the GFC in 2008

Exh 18: Std. dev of returns for tech stocks with >$1B in market up to Sep 2020

offset their respective weakness in printing and enterprise servers. HP is in our model portfolio and delivered upside vs. the S&P500 while trailing our benchmark slightly. We do see some potential in the disc drive makers, in IBM and in Motorola Solutions. Nutanix, which is not on the list because it is not yet profitable (it has no P/E), may make it past some value screens with its 3.7x P/S. The rest may be sailing in troubled waters for longer than many investors seem to be assuming.

Adding Mercado Libre

Our portfolio is heavily skewed toward the enterprise shift to the cloud, with 5 SaaS application vendors (AYX, ZEN, TEAM, PS, TWOU), 2 cloud-based cybersecurity names (OKTA, ZS), the biggest enterprise software company (MSFT), a hybrid cloud software supplier (NTNX), a PC/printer vendor (HPQ), a top supplier to hyperscale datacenters (NVDA) and the fastest growing CDN (FSLY). Given the potential in e-commerce and digital media, we will add Latin American e-commerce leader Mercado Libre. MELI delivered 61% sales growth in its recent report, beating consensus expectations by 1780 bp. Forward estimates are pessimistic, expecting a fairly sharp deceleration into 2021. We see substantial room for future surprises and upward revisions (Exhibit 19, 20, 21).

To make room, we are removing Alteryx, which has more than tripled since we added it to the portfolio in May 2018. While we see substantial future upside for the company, which sells cloud-based software to aggregate data from disparate formats into a single coherent dataset, the product is complex, the sales cycle

Exh 19: MercadoLibre Quarterly Revenues and YoY Growth for last 2 years

Exh 20: Consensus growth estimates for MELI leave ample room for surprises

is long, and IT management is focused on coping with the huge shift to WFH rather than big data projects, at least for the time being.

Exh 21: Summary of Changes to the SSR TMT Model Portfolio

Exh 22: SSR TMT 15 Stock Model Portfolio – RECONSTITUTED

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