Quick Thoughts: 1Q Earnings – Bring on the Megacaps

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

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May 4, 2020

Quick Thoughts: 1Q Earnings – Bring on the Megacaps

  • The 2nd week of TMT earnings brought results for the 5 biggest stocks and a clearer view of what’s going on. Digital ad spend doesn’t seem as bad as the bears feared. Cloud software had a great 1Q even if visibility is a bit murky. E-commerce is selling like gangbusters, but the crisis has costs up big. Smartphones weren’t as bad as feared, but the worst could be to come.
  • Analysts were piling on GOOGL ahead of its earnings, fretting about exposure to travel and small businesses. Management gave a rosier view that was echoed by FB the next day – both stocks soared. TWTR was gloomier, washing out the digital ad rally. We think the group will be pretty quick to recover.
  • MSFT crushed it as expected and gave confident guidance. So did NOW. TEAM and ZEN posted excellent numbers but cast more cautious guidance. We think SaaS solutions will be big beneficiaries of the pandemic long-term, even if social distancing means it takes longer to close new business.
  • AMZN results – big sales growth and much higher costs – shouldn’t have surprised anyone but they did. As we wrote last week (E-Commerce in the Time of COVID-19) this starts a new period of company investment and jumps it ahead on several lucrative opportunities.
  • AAPL and QCOM cast a rosy glow on a tough quarter for smartphones. Both see phone sales down big in 2Q but are planning for a China-led 2H rebound. We are skeptical, and since both stocks were down a bit on their reports, perhaps the market is too.
  • Next week is lighter for TMT earnings. Tuesday brings DIS’s train wreck – parks closed, cruise ships docked, movie theaters shuttered, PayTV systems demanding money back from sports-less ESPN, TV ad spending down hard – all with no real end in sight. SQ will report a big revenue hit a day later but could talk up growth in e-commerce and big post-crisis opportunities. AYX should be similar to other SaaS peers – an unequivocal beat for 1Q but extraordinarily little forward visibility.
  • None of these companies has any idea what to expect from 2H20. Any credible guidance should be wide enough to drive a truck through it.

More than $4 trillion in TMT market cap reported earnings last week, casting a brighter light on the melodrama that is the COVID-19 pandemic. Some market hypotheses were confirmed, and others were refuted. Some managements expressed confidence and optimism, while others were cautious. Maybe investors learned something useful, but then again, maybe not.

We thought there were some valuable takeaways. First up on Tuesday was Alphabet. Leading up to earnings, the dominant narrative was disaster, with analysts playing up the company’s exposure to travel-related

Exh 1: Google Cloud Platform and YouTube YoY Sales Growth Rates

Exh 2: YoY Sales Growth and Operating Margins Trends for Alphabet

Exh 3: Snapshot of Total Monthly Active Users Across All of FB’s Properties

companies and small businesses, both of which, presumably, would be too damaged by the crisis to spend on ads. When Snap sounded a more optimistic note, it was quickly sloughed off as idiosyncratic, tied to the youthful Snap demographic rather than any resilience in the overall ad market. Thus, when the GOOGL beat hit the tape, shares popped, and popped again when CEO Sundar Pichai suggested that ad revenues seemed to stabilize at the end of April. The story was echoed the next day by Facebook, which also saw signs of hope from its ad buyers. Of course, both companies absolutely killed it on measures of engagement. For Alphabet, YouTube and its cloud business showed stalwart growth (Exhibit 1, 2), while Facebook posted MAUs tantalizingly close to 3 billion people (Exhibit 3). The social media party cooled off a bit on Thursday, when Twitter failed to share the rosy perspective given by its big brothers, but the street has had to adjust the tone of the narrative. FWIW – we think 2Q ad spending will be weak but that digital share gain vs. traditional media will temper the downside. We also expect ad spend to be early to recover (as it has in other recessions) and that the share shift to digital will be permanent. We are bullish on these stocks.

Microsoft posted on the same day as Facebook. Investors were expecting big things and they got them. Accelerating sales, expanding margins, impressive cloud gains – there was nothing to criticize. Not only did the nearly instantaneous transition to work-from-home benefit a range of Mister Softy’s biggest products, but it seems to have moved up the enterprise timetable for transitioning to the public cloud (Exhibit 4). This is good, not just for Microsoft but for many best-of-breed cloud software providers, some of whom reported in the company’s wake. Service Now, Zendesk and Atlassian all posted big upside for 1Q, but hedged to various degrees in providing guidance for 2Q. These companies do not have the breadth of

Exh 4: MSFT Azure Cloud Sales YoY Growth Rates, 4Q16 to 1Q20

customers that Microsoft does – few do – and leaving a lot of wiggle room seems prudent given the conditions out there. Nonetheless, Zendesk and Atlassian were spanked for their lack of conviction, even though the companies are better positioned now than they were before for the eventual cloud future. We would be buyers of the whole group.

The response to Amazon’s report was almost comical. E-commerce sales, at a time when a third of the world’s population is largely confined to their homes, was up big. COGS and expenses, at a time when supply chains are precarious, delivery resources are in short supply, and pressure to provide protection and battle pay for fulfillment center employees is ratcheting ever higher, were also up big (Exhibit 5). We were like “I’m shocked, SHOCKED to find gambling going on here”. Still, investors sold off the stock on the “news”. Amazon is going to take full advantage of this crisis to redouble its investments in signing on more Prime members; expanding into grocery, pharmacy, and other new categories; and pushing into new geographic markets. Margins will be weak for a while. Sales growth will be great. Yes, some rivals will also be along for the ride, but Amazon will be the big winner. Investors should be buying.

Qualcomm and Apple tried to put a positive spin on a tough 1Q for smartphones. It seems the quarter breaks into three – hot sales during January, an abrupt downturn in China during February while the rest of the world continued apace, then everything went south in March. Qualcomm was able to post growth because it had resolved conflicts with Apple and others in 2019. Apple offset declining iPhone revenues with upside in wearables and services. 2Q smartphone sales could be down 20-30% YoY, but both

Exh 5: AMZN YoY Sales Growth and Operating Margins, 1Q17 to 1Q20

wireless leaders were more optimistic for the second half, with Qualcomm reiterating its precious guidance for 175—225M 5G phones sold worldwide for 2020. We were left scratching our heads a bit. Chinese carriers (undoubtedly prompted by the government) are still holding to their projections of 110M 5G subs by year end – maybe, if there isn’t a second wave of infection and if a traumatized populace can be prodded into opening their wallets for new devices that cost weeks of earnings. Meanwhile, outside of China, stores remain closed, people are unemployed, and many carriers have put 5G network deployments on hold and cannot be counted on to for promotion spending. Word is that Apple has cut production orders by 20% for 2H20 and that its 5G flagship iPhone will be available in extremely limited quantities in the Fall. We’ll pass on these stocks for now.

Next week will not be nearly so busy. Disney, which reports on Tuesday, looks to be a dumpster fire. The parks are almost all closed, and the Chinese operations have reopened to attendance a small fraction of normal. Four cruise ships are docked, and hotel rooms are empty. Movie theaters are closed, and the company has pushed all of its new film release dates well into the future. No one knows when consumers will be comfortable sitting in the dark for two hours with hundreds of strangers. ESPN has no sports to show and PayTV operators are rumbling about applying force majeure clauses to back out of fee obligations. Advertisers are reprioritizing their budgets away from linear TV. Disney+ and Hulu are doing spectacularly well, but they aren’t yet profitable and will likely run out of new content well before year end given that global production has been shut down. We think it could be a few more quarters before we hear any good news.

Model portfolio constituent Square will also likely share bad news next week (Exhibit 6). Most of its revenue comes from processing transactions for small retailers at point of sale. Most of these stores are closed. Still, its growing business of facilitating online sales for merchants is growing even faster and its Square Cash utility for person-to-person payments is a big beneficiary of the current environment. It has also gained notice for helping small businesses get loan relief from the SBA. We think the company has a bright future beyond the pandemic, even though the next quarter or two will be tough. Finally, Alteryx, also part of our model portfolio, reports on Wednesday. We think it will follow its SaaS peers with strong 1Q results and uncertain 2Q guidance.

Exh 6: Highlight of Key TMT Earnings for Week of May 4, 2020


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