Portfolio Update: The Megacaps and the Pandemic

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

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March 23, 2020

Portfolio Update: The Megacaps and the Pandemic

TMT stocks have battered along with the broader market during the corona virus crisis. As investors start to look forward toward recovery, one of the first questions concerns the 5 tech megacaps – MSFT, AAPL, AMZN, GOOGL and FB – which still make up 18% of the S&P500 market cap. Assessing these companies on five areas of risk, we believe AMZN, GOOGL and MSFT are well placed to outperform during recovery, while we have concerns for FB and, in particular, AAPL. Our three favored picks all benefit from social distancing and work-from-home, and while there are some mitigating near-term risks, we believe all three to be positioned to return to their prior trajectories. FB is also a beneficiary of social distancing, but we believe the stock will continue to struggle until the costs of monitoring the content on its platforms stabilize and the threat of government intervention is neutralized. As for AAPL, we believe that the demand for iPhones will be sharply lower than expected, with new models weeks or even months behind schedule. Meanwhile, our model portfolio saw its substantial outperformance erased over the past month. Still, we beat the S&P500 by 1106 bp and eked out a 272 bp lead over the tech benchmark since our last update. We have decided to remove IBM and KEYS – as we believe their businesses will be slower to recover – replacing them with ZS and TEAM.

  • Pandemic pain is not spread equally. We published a companion piece that describes our framework for assessing company exposure to the coronavirus crisis, breaking risks into 5 buckets – 1. Demand; 2. Distribution; 3. Operations; 4. Development; and 5. Idiosyncratic. In our assessment, AAPL is the most vulnerable of the megacaps, with significant and lingering risks in all categories. The others face more generalized risks from recession but have some mitigating factors that may see them less affected than the average TMT company.
  • Social distancing works for AMZN. Historically, investors have given AMZN substantial license to hide profits under huge investments that run through the P&L. However, this faith has periodically frayed, prompting CEO Bezos to step back and allow the potential for profitability to peek from behind the curtain. The December quarter is an example of this, and likely, a harbinger of a few upside margin surprises to come. The long run steady state profitability potential is even higher than that, but AMZN still has substantial high-return investment opportunities in front of it. The pandemic brings huge opportunity for e-commerce, but we note the risk of labor shortages in fulfillment and delivery.
  • GOOGL is an essential service. Yes, the crisis will hurt ad sales, and yes, travel services and small business ads are important for GOOGL. Still, engagement on the core franchises is booming, and in recovery precise targeting will be ever more valuable. Meanwhile, work-at-home is a major boon to the newly broken out cloud business and several “other bets” like Waymo, Verily, and consumer financial services are extremely well positioned to prosper post pandemic. In recent years, GOOGL has consistently traded at a PEG discount to its megacap peers. We believe increased transparency under new CEO Sundar Pichai will help close that gap as the company flourishes in the recovery.
  • MSFT is in exactly the right place. The exodus of enterprise IT to the cloud is one of the greatest value creation levers of our time. No company has more exposure to the cloud than MSFT. We believe Azure (growing 62% YoY) is on track to overtake AWS within 5 years, while Office 365 is the world’s leading SaaS application. While management warned of a hit to PC sales from the pandemic, more recent news flow suggests a boom as self-isolated workers upgrade their home offices. This is portends new demand for MSFT’s SaaS productivity software as well – Office 365, Teams, Outlook, etc. Azure is also well placed to shrug off the recessionary pressures of the contagion. Still, the prevailing narrative on the company is overwhelmingly positive and it will be more difficult for MSFT to deliver big surprises.
  • FB is sticking to its knitting, but the yarn is getting tangled. Like GOOGL, FB’s core franchises are seeing big increases in engagement but also face an ad market hit by recession. Once we shift into recovery, this ought to play to FB’s benefit given its extraordinary reach and targeting. Still, there are real risks for investors. FB is the most vulnerable to regulatory/legal intervention. Second, the costs of content monitoring and privacy compliance are higher than anticipated, hitting margins. Finally, FB has not effectively diversified beyond ad-supported social media and messaging. When its core business inevitably slows, we are not confident that it has other initiatives to pick up the slack.
  • 2020 could be a lost year for AAPL. The 89% rise in AAPL shares in 2019 was driven by anticipation of a 5G driven replacement upcycle in 2020, despite the reality that there would be no 5G iPhone until FY21. Reports suggest that the COVID-19 crisis saw smartphone demand in China down 60%+ this quarter, and with the worst of the virus now hitting N. America and Europe, 1HCY20 looks to be a lost cause for AAPL. Even with a rapid recovery, the impacts to the supply chain will likely cause meaningful delays in the introduction of new products planned for the fall, and the weakened global economy will hinder any rebound in phone replacement. Despite all of this and a vague pre-announcement, FY2020 EPS estimates are still higher than they were 90 days ago. We see significant downward revisions coming once management clarifies its outlook at its next quarterly call.
  • Our portfolio is weathering the storm. A month ago, a very strong earnings season saw our model portfolio up 22% since early December, well ahead of both the S&P500 and our tech benchmark. Since then, the pandemic has hit performance hard, leaving us down 15.4% in absolute, but up 2.7% vs. the tech benchmark and up 11.1% vs. the broader market. We see most of this damage as short term. In previous 10%+ market drops, growth tech has led the way back, returning to peak in 135% of the days that it took to reach a trough, and outperforming by 635bp during that recovery. We believe that our primary themes – enterprise cloud (SaaS, hybrid architecture and hosting), early phase 5G, cybersecurity, digital ads, streaming, and e-commerce – are likely to be robust relative to the broader TMT market as the world recovers from the coronavirus crisis.
  • Replacing IBM and KEYS with TEAM and ZS. The 1Q20 earnings season will be brutal. We believe IBM, which has long sales cycles and a huge consulting arm laid fallow, and KEYS, which relies on network deployment and product development activities now on hold, could be particularly hard hit. We note that both could see their way back in once the market stabilizes. In their place, we are adding TEAM, which should see benefit from work at home activities, and ZS, advantaged by heightened cybersecurity risks.

Recent Megacap History

Microsoft and Apple each sport market capitalization of more than $1T. Amazon is knocking on the door of rejoining the trillion-dollar club, while has fallen back to about $920B. Facebook is the sluggard of the group with a cap of “just” $430B. Together, these stocks make up more than 18% of the S&P500 by market cap and accounted for 35% of performance for that index in 2019. No portfolio with a broad mandate can afford to ignore these stocks.

Last year, the right choice was to heavily overweight Apple (+89%), Microsoft (+58%) and Facebook (+51%). In contrast, Amazon (+20%) and Alphabet (+27%) both underperformed the broader market Exhibit 1, 2). So far this year, in the midst of the corona virus crisis, Amazon is the clear winner of the group, more or less flat for the year. Microsoft is second in line, having bled off about 14% of its cap since the start of the year despite blow out earnings. Apple (-23.5%) has been surprisingly strong, down less than the S&P500 despite its obvious exposure to the worst of the pandemic (Exhibit 3). Alphabet (-22.0%) is faring a touch worse than Apple, while Facebook (-28.6%) has been the dog so far, missing 4Q19 on higher than expected expenses.

What Does Coronavirus mean for MAAAF?

A pandemic which sends a meaningful percentage of the world’s consumers into social isolation, demands that factories seriously curtail their output, and disrupts transportation across all of it will have implications for every company. We recently published our framework for evaluating crisis-related risks for TMT companies (Quick Thoughts: Waiting for The Bottom) focusing on the impact on 1. Demand; 2. Sales and Distribution; 3. Operations; 4. Development; and 5. Idiosyncratic factors.

Demand Risks – The course of the pandemic affects the ability and willingness of possible customers to buy products and services. For businesses that sell directly to consumers, social isolation measures squelch traffic to physical retailers, many of which are temporarily closed, while cutting off spending on travel and group activities. Moreover, the economic uncertainty from lost earnings and unexpected expenses could stretch well past the nadir of the actual disease, depressing discretionary spending. This impact is obvious on travel related businesses like OTAs and theme parks, and on businesses that depend on group gatherings, such as movies, but in recession, most companies see some muting of demand. Still, with the specific nature of this threat, there are businesses that will see new demand. For example, companies that enable work from home and distance learning (e.g. SaaS productivity applications, telepresence tech, cybersecurity, etc.), e-commerce platforms, streaming media, and the video game ecosystem have all reported sharp increases in engagement. Some of this may prove to be relatively permanent.

Sales/Distribution Risks – Many retail stores are closed. For the shops that remain open, foot traffic is a small fraction of normal. E-commerce platforms are enjoying an obvious bonanza, but these companies could face pressures down the line if labor shortages constrain their delivery partners. Amazon has already warned 3rd party sellers that it will prioritize health related items and other staples. In the enterprise, sales reps cannot meet face to face with customers. These obstacles are particularly troublesome for physical products that must be stocked and delivered, for sales that require hands-on comparisons, and for


Exh 1: YTD performance of Big 5 megacap technology companies

Exh 2: 2019 performance of Big 5 megacap technology companies

Exh 3: Top 10 companies in S&P 500 and their stock performance in recent past

complicated B2B transactions that require more than a teleconference to close deals. This also favors TMT companies with significant revenues on subscription such as telecom carriers or SaaS applications.

Operations Risks – Modern manufacturing requires orchestrating an ecosystem of suppliers and manufacturing partners into precise motion, maximizing speed and minimizing costly inventory at every step. For many hardware makers, relying on Asian partners for parts and assembly, the supply chain has been paralyzed for weeks. Turning the engine back on is not a function of simply reopening the assembly plants – workers need to return to efficiency, but the flow of needed parts must also be up to speed. This is much more difficult than it sounds. A single fumble by a single supplier can set back the whole chain and the threat of a second wave of infection is omnipresent. Companies up the chain making parts for the whole have very little visibility beyond customer orders, are typically required to hold inventory risk, and may be more badly damaged by the crisis than the primary brand. Down the chain in distribution, companies face the threat of labor shortages and sudden edicts that could disrupt their operations (Exhibit 4).

Development Risks – New products and enhancements are developed by teams of engineers, now scattered to their work-at-home desks. At the very least, this displacement and the distraction of the unfolding crisis is likely to damage productivity in the immediate term. For hardware products, this will be much more vexing, as building prototypes and testing sample components will be nearly impossible outside company laboratories. Moreover, the process of transitioning products into physical production will be badly disrupted even if manufacturing partners have reopened for business. Ramping to production is an iterative and cooperative process requiring teams of engineers from the various parts of the ecosystem to collaborate face to face in bringing product to final specs and the manufacturing lines to speed. For example, we anticipate multiweek delays in bringing new smartphones to market, pushing normal September and October delivery dates perilously close to year end and, likely, limiting the volumes available ahead of the holiday.

Exh 4: Brief summary of disruptions faced by TMT companies

Idiosyncratic Risks – The nature of the coronavirus crisis raises some atypical risks. For example, the sudden dispersion of workers to their homes and the resulting rush of remote traffic is field day for hackers. Companies with inadequate safeguards may find themselves victims of fraud, theft, sabotage, and other cybercrimes.

Amazon Was Built for Social Distancing

By all accounts, Amazon is awash with business from newly shut in consumers. Indeed, the company has had to begin triaging orders, prioritizing health related items and staples over more discretionary goods. As such, Amazon shares have fallen just 12% in the past month, significantly outperforming the other megacaps over that stretch. Still, the stock underperformed its peers in 2019, up 20.1% for the year but trailing the 28.7% rise of the S&P500. This was unusual – Amazon stock has beaten the broader market by an average of 2253 bp per year over the last decade. Like Alphabet, Amazon has been historically tightfisted with information for investors, often surprising the market with unexpected bursts of expenses from investments in growth initiatives run through the income statement. In 2019, a 30% jump in OPEX related to the push to same day delivery blunted earnings growth to about 15% against sales growth of more than 20%, the likely catalyst for the uncharacteristic weak performance of the stock (Exhibit 5, 6).

Still, the underlying profitability of Amazon remains strong, and when investment spending periodically wanes, investors get a glimpse. The 4Q19 report was such an occasion, with earnings beating consensus by a whopping 63%. Typically, these stretches of restrained spending last longer than a quarter, and with the strongly profitable AWS growing at twice the pace of Amazon’s core business, there is a bit more cushion for overall margins. Moreover, within the massive e-commerce platform, third party sales are growing at nearly twice the pace of Amazon’s own retail business. These sales are particularly lucrative for Amazon,

Exh 5: AMZN worldwide shipping costs are growing due to 1-day shipping program

Exh 6: FY19 OPEX for AMZN grew 21%, primarily due to 1-day shipping program 













Exh 7: Summary of AMZN avg. top and bottom-line surprises in most recent years

which recognizes the fee for services as revenue with substantial margins above cost and does not carry the inventory on its own books. We believe this is a powerful impetus to improving profitability going forward (Exhibit 7).

AWS is also an impetus to better margins. We believe that the global TAM for cloud hosting is in the range of a trillion dollars, giving AWS ample room to maintain its 40%+ growth rate despite the continued strength of Microsoft’s Azure and the surprising rise of Google Cloud Platform. This business should maintain its momentum coming out of the crisis. Even in recession, the shift to the cloud is a top priority for IT departments, promising lower overall costs to boot.

Looking forward, Amazon is likely to emerge from this crisis even more dominant than it was before it began. There are some risks– governments could order fulfillment centers closed or deliveries suspended to protect workers in a worst-case scenario, worker absences due to illness could stretch delivery intervals and sow customer dissatisfaction, etc. – but we are confident that Bezos and company will navigate them cleanly.

Alphabet Opens the Curtain a Little

Advertising spending has historically been quite sensitive to recession – ad spend was off 13% YoY in 2009 at the onset of the last recession. The mechanics of this crisis are particularly harsh for the travel industry and for small local merchants, historically a disproportionate share of Google ad spending. However, we believe several factors at least partially mitigate this negative impact. First, in previous recession, the most direct forms of advertising, such as direct mail, have seen significant share gains at the expense of more generalized brand advertising. Second, social distancing is generating significantly higher engagement for Google, and thus greater ad inventory to sell at auction. Third, the targeting capabilities for Google’s platform are likely to be especially valuable to advertisers looking to jumpstart business coming out of this period of seclusion. In the long term, this downturn is unlikely to have any lasting negative impact on this core business.

Meanwhile, the pandemic may strengthen other businesses under the Alphabet umbrella. Google Cloud, now broken out as a separate revenue line, delivered 53% YoY growth in FY19, with substantial share gains in the hosting segment (Exhibit 8). During the crisis, growth in work-at-home will drive paid volume in GCP’s hyperscale datacenters, use of the company’s SaaS productivity software suite and in its teleconferencing service. Waymo, will continue its service in Phoenix without Human Safety drivers, racking up miles and further solidifying its leadership in self-driving technology. The Verily health sciences initiative has been enjoined to build a cloud application to help direct and track coronavirus sufferers’

Beyond the immediate impact of the pandemic, we see Alphabet as underappreciated by investors. It has historically combined the obsessive secrecy of Apple with the indifference to investors of Amazon into a policy of near perfect obfuscation. For shareholders, this has been frustrating, as quarterly earnings reports periodically blow up the stock on unexpected operating expenses or poorly telegraphed seasonal revenue fluctuations that could easily have been navigated with more transparency to the workings of the business.

Exh 8: Google Cloud Platform Annual Sales and YoY Growth Rates, 2017 – 2019

Thus, a company that has grown its $160B+ in annual sales at nearly 18%YoY and maintained better than 22% operating margins trades at only a tiny premium to the market P/E multiple (Exhibit 9).

We think Alphabet could break out in the post-crisis recovery. The ascension of Sundar Pichai to the CEO office seems to have brought a willingness to be a bit more open. In the recent quarter, the company broke out sales results for YouTube and Google Enterprise. These businesses are big enough to largely offset deceleration in the core search franchise, and considered separately, each deserves a substantial multiple premium relative to the broader market. YouTube generated sales of $15B in 2019, up 31% YoY, and while the company didn’t report margins for the unit, it is believed to be solidly profitable although unlikely nearly as lucrative as the search franchise (Exhibit 10). Netflix – about a third bigger in sales than YouTube, growing at a similar 30% YoY pace and with operating margins (12.9%) well below Alphabet (22.5%) – is as good a comp as any, and sports a better than 7.5x ttm sales multiple even after the market plunge. In this context, as an independent business, we might expect YouTube to sport a better than $100B market cap.

Google’s cloud business, which includes its Cloud Platform (GCP) hosting operation and its GSuite application software, generated sales of $8.9B in 2019, up more than 60% vs. 2018. Salesforce, which has double Google’s cloud sales but is growing at a third of its pace and has thin 4% operating margins, trades at an 8x sales multiple. Workday, which is less than half the size of Google’s enterprise business and is growing at less than 25% YoY, carries a 10x sales multiple. Given the growing momentum in GCP, this business too would likely top $100B valued as an independent company.

Waymo, Alphabet’s self-driving operations, recently raised $2.5B in outside funding at a total valuation reported to be ~$30B. We were a bit shocked at this, as GM Cruise, years behind Waymo on the path to commercialization, raised funds at a $20B value a year ago suggesting that the Google initiative could be worth multiples of that. Alphabet, having already sunk billions of dollars of investment in developing, testing, and beginning the commercialization of self-driving robo-cab technology, would seem to be selling itself short. Still, the funds are likely earmarked for expanding into new markets, with Los Angeles the probably target. We believe success is likely, placing Waymo as a serious rival to Uber and Lyft with dramatic cost and operating advantages. Another of Alphabet’s “Other Bets”, life sciences AI initiative Verily, has raised $1.8B in outside funding, suggesting that it too has been valued at well above $10B. Positive news flow in these businesses or in other initiatives could spur meaningful new value for the parent stock.

Meanwhile, core Google remains a juggernaut. Backing out YouTube, its advertising revenue was about $120B in 2019, growing at better than 15% and wildly profitable. Almost all of Alphabet’s $35B in operating profit can be attributed to this franchise. Even with a market multiple – the S&P500 currently trades at 18 times trailing earnings – core Google would be worth nearly $700B, and we would argue its consistent growth and the optionality of under-monetized franchise services like Maps or Photos should be worth a premium vs. the average stock. Add in the potential of Alphabet’s initiatives in health care, consumer finance, e-commerce, etc., and we see substantial upside to the current $750B market cap (Exhibit 11).

Transparency is the key to unlocking this value. We are hopeful that we will get more of it as 2020 unwinds, making Alphabet one of our best bets amongst the MAAAF stocks.

Exh 9: GOOGL Historical Sales Growth and Operating Margins Trend

Exh 10: YouTube Annual Sales and YoY Growth Rates, 2017 – 2019

Exh 11: GOOGL is trading at significant discount to value of its diverse segments

Microsoft Wins at Work at Home

Back in February, Microsoft issued a partial preannouncement suggesting that disruptions in the production of PCs in Asia would result in weakness for the parts of its business directly tied to computer unit sales – most notably Windows licenses, which constitute about 16% of company revenue. However, recent reports suggest hot demand for new laptops for workers displaced from their offices, perhaps a harbinger that the weakness may be relatively short lived once the factories can return to volume output. While that return will not be instantaneous, we believe that it may recover somewhat faster than smartphone production, given broader options for sourcing parts, less sophisticated production needs, and much greater geographic diversity in the manufacturing base. Longer term, we believe that the trend to greater work-from-home may remain even after the current corona virus threat wanes.

This will be very good for Microsoft, beyond the impact on PC unit demand. Microsoft Office 365 is the dominant platform for productivity apps. Microsoft Teams leads in collaboration software. Skype is a top ad hoc video conferencing platform. Outlook is the leading enterprise email solution. Microsoft has a well-established platform for enterprises to manage work-at-home employees. Microsoft Azure is the number two cloud hosting solution, gaining quickly on AWS (Exhibit 12, 13).

Of course, investors are no longer skeptical about the Microsoft story. While published consensus for most stocks still includes analyst estimates published before the realities of the crisis were apparent, we expect that the revised expectations for Microsoft will still set a fairly high bar for the company going forward. Still, we are confident enough in its positioning and execution to believe that Microsoft will still surprise, although perhaps with less upside than the stock offered the last several years.

Facebook is Paying to Police Content

Facebook took a hit on its earnings well before the worst of the pandemic news hit the tape. CEO Zuckerberg seems to have taken the widespread criticism of his company’s role in disseminating false information seriously, hiring to greatly expand the staff asked to monitor accounts, posts and links for

Exh 12: MSFT Azure Cloud Historical YoY Growth Rates, 1FQ16 to 2FQ19

Exh 13: MSFT Quarterly Sales and Growth Rates, 1FQ17 – 2FQ19

Exh 14: FB top-line sales growth and operating margins trend – growth is tapering, and costs are increasing

egregiously misleading content. In doing so, Facebook hopes to avert regulatory solutions that could be imposed from the outside and to dampen enthusiasm for antitrust activity in the US and Europe. This has come at a cost, and investors are uncomfortable with the uncertain effect on sustainable margins and with the ongoing threat of government intervention. Now, with a recession potentially looming, the likelihood of a downturn in ad spending adds to the market’s discomfort.

We are not worried about the top line (Exhibit 14). Social networking is the perfect answer for social distancing, and we suspect that Facebook will reveal extraordinary increases in engagement during this crisis. Engagement drives ad inventory, and even if pricing at auction falls, we expect volume to remain strong. However, even if we believe that revenues are likely to see less of a hit than pessimistic narratives suggest, the uncertain long-term costs of content scrutiny remain a major issue that is unlikely to go away until the company and regulators come to an understanding, and a sustainable cost structure becomes apparent. This issue will be back on the front burner again once the panic over the virus ebbs, although it is possible that calls to break up the company will find less traction.

Apple Bulls are not Paying Attention

In February, Apple’s Chinese assembly partners closed their plants and Apple closed all of its Chinese retail stores. Reports show February smartphone unit sales in China down more than 60% YoY, in a market that

Exh 15: Consensus expectations on AAPL are overly aggressive for 2020 and 2021

makes up nearly a quarter of Apple’s sales. Harsh measures by the Chinese government seems to have brought the disease to heel in that country and Apple’s factories and stores are beginning to reopen, but much damage has already been done. It will be interesting to see whether the government’s aggressive propaganda can get Chinese consumers, many of whom have lost weeks of wages, back into the market for super-premium iPhones. We think it is unlikely that that market will return to YoY growth until the easy compares roll around next year.

While the Chinese stores reopen, Apple has now closed its stores in the rest of the world without an obvious timetable for them to return to business. Shell shocked consumers, many facing severe economic consequences, are unlikely to prioritize phone upgrades or even new peripherals. The availability of the most popular products could be compromised for months given the complexity of reviving just-in-time supply chains. There are hundreds of participants in the ecosystem and all must be in synch.

New products, such as the 5G iPhone 12 previously expected in September, are almost certainly to be delayed, as travel bans and appropriate caution, keep development teams out of their labs and unable to spend the requisite weeks on site in China helping to set up manufacturing. It is possible that the new models will not be in stores in time for Christmas, even if the world’s consumers were ready to buy them. 5G network deployments have also slowed, meaning the impetus for stepping up for a 5G phone may not even be ready for many markets until 2021.

It is likely that Apple revenues for calendar year 2020 will be down double digits YoY. It is likely that margins, hit both by the scale effects of the revenue miss and by the extraordinary costs of bringing the

production line back up while closing and opening stores worldwide, will be down sharply. None of this is reflected in consensus expectations, so we expect sharp downward revisions (Exhibit 15).

Our Model Portfolio Performance

For the roughly 3 months since our last update on December 9, 2019, our 15-stock model portfolio declined by 1544 bp, beating the S&P500 by 1106 bp, and the tech components of that index by 272 bp (Exhibit 16). The sharp crisis-related declines of the last month erased what had been an excellent quarter for the portfolio, which had been up by 2187 bp at its peak on February 19 in absolute terms and 1389 bp ahead of the S&P500. 13 of the 15 stocks beat consensus expectations for the latest quarter with the highest average upside sales surprise in more than 4 years, a small consolation considering the carnage that followed (Exhibit 17, 18). Our worst performers all in were NTNX (-56.9% since 12/10/19) which has failed to adequately explain the implications of its business model transition for investors, and SQ (-43.2%) which is viewed as especially vulnerable to the pandemic given its exposure to small retailers and restaurants. Our relative bright spots have been NFLX (+10.0%) and AMZN (+5.5%) both of which are viewed as beneficiaries of the social distancing measures in place over much of the developed world, and TMUS (-1.7%), which received a favorable court ruling that cleared the way to complete its merger with Sprint.

Exh 16: Model Portfolio relative performance vs. benchmarks since last update

Exh 17: Surprises posted by model portfolio constituents in most recent quarter

Exh 18: Historical quarterly surprises by model portfolio constituents last 4 years

Exh 19: SSR TMT 15 Stock Model Portfolio Performance Since Last Update

Removing IBM and KEYS, Adding TEAM and ZS

IBM investors have been snake-bit. In January, after many months of anticipation, CEO Ginny Rometty stepped down in favor of IBM cloud head Arvind Krishna after delivering a sharp upside quarterly beat with the promise of sustainable growth. The stock made a 52-week high in February and looked ready to breakout. Unfortunately, the COVID-19 pandemic has pushed out the new era of sustainable growth indefinitely. IBM’s business depends on long sales cycles and expansive consulting engagements that will be badly derailed by global social distancing edicts. While we are confident that the company will survive and come to thrive in years to come, near term results could be relatively poor and the investor community is likely to have little patience for what had been a shared punching bag for much of the past few years. We will remove it now and look for a better time to re-engage.

Keysight has been a great stock for us, up more than 100% in roughly 32 weeks in our portfolio. Its fortunes are tied to 5G network deployments and new 5G device development efforts that will be delayed by the virus. While we are long term 5G bulls and expect nearly every carrier world-wide to shift to the technology, sharp declines in mobile traffic related to social distancing efforts removes some of the near-term impetus for carriers to invest. As such, we will remove KEYS from the portfolio.

In turn, we are adding Atlassian and ZScaler. Atlassian (TEAM) offers a suite of cloud-based project management software products that have deeply penetrated software development organizations. The value of the Atlassian platform is magnified by the rush to work-at-home for desk-based workers. A release of a free-ware version of its most popular products for groups of fewer than 10 collaborators could prove an excellent took to drive sales as workers and their employees discover the benefits to their productivity working remotely. The company had been growing sales at nearly 40% annually, and while the crisis may hold up contract closings, we believe it has catalyzed a long-term shift toward greatly increased work-from-home that will greatly benefit Atlassian. Off about 17% from its peak, we believe the current price is an excellent entry point for a best-in-breed SaaS category leader with obvious strength in remote work solutions.

ZScaler is also well placed to benefit from the tide of remote workers (Exhibit 20). Its primary products funnel incoming and outgoing enterprise traffic through its cloud-based security platform, managing credentials and looking for threats. Employees in their home offices need not implement secure virtual private networks, as their connections into the enterprise network via the internet first pass through ZScaler’s servers. The stock fell more than 35% from its post-earnings February highs before rallying back in the last week. Nonetheless, shares are still down 18% and it trades at a sales multiple slightly better than half where it had been a year ago. Looking forward, we expect the increased prevalence of work-at-home to generate significant new opportunities for the company (Exhibit 21).

Exh 20: Summary of Changes to the Model Portfolio – replacing IBM, KEYS with ZS, TEAM

Exh 21: SSR TMT 15 Stock Model Portfolio – RECONSTITUTED


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