Quick Thoughts: Growth TMT is (Mostly) Safer than You Think
SEE LAST PAGE OF THIS REPORT Paul Sagawa / Artur Pylak
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January 18, 2016
Quick Thoughts: Growth TMT is (Mostly) Safer than You Think
The market has begun 2016 with a nasty flu and a threat that it could spread into a global recession. TMT stocks, and in particular, the cloud-focused stocks that led the market in 2015, have been badly hit. While these names have high multiples and high betas, we believe that their business results are likely to be far more resilient, even in the midst of a recession, than most other parts of the economy. First, the causes of the current market downturn have very modest impact on the “FANGs” (FB, AMZN, NFLX, and GOOGL) and many of their peers. Some of these companies have been blocked from competing in China, none of them are affected by oil prices, and most play little role in industrial production. All have already borne the weight of FX in 2015 and are prepared for more of the same in 2016. Importantly, most all cloud-based businesses are deflationary, offering lower costs for their customers vs. traditional business models, and thus, positioned to exploit recessionary conditions for market share gain. We note that AAPL, GOOGL, AMZN and NFLX all grew sales at a 20%+ CAGR from 2007-10, earnings at 25%+, and appreciated at better than 24% annually after the initial 2008 drop. Even MSFT grew EPS at a 6.6% annual pace and appreciated 14.5% over the same time frames. Given all of this, we support our model portfolio picks despite current market conditions and the risk of recession.
- Top TMT Stocks Hit Hard – Since the start of 2016, our large cap model portfolio has underperformed the S&P 500 by 201 bp, as high multiple, high beta names like NFLX, GOOGL, AMZN and FB have fallen significantly more than the overall market. We believe that the sentiment on these stocks is misplaced and expect them to be significant outperformers going forward.
- Low China Exposure – GOOGL, FB, AMZN and TWTR have been badly disadvantaged in China by government censorship, regulation and strong indigenous competitors. Likewise, US wireless plays TMUS and CCI have no exposure. On the flip side, QCOM, with royalties to collect, has significant exposure to currency devaluation and a possible slump in Chinese smartphone demand. DIS has significant exposure for movies, consumer products and theme parks. STX likely derives 20-25% of its sales from component sales to Chinese OEMs – these revenues will be largely dependent on end market demand. MSFT may have as much as 10% exposure, also largely owing to sales of Windows and Office bundled with Chinese made PCs. NOK got 8% of its sales from China in 2015.
- Cheap Oil and Slowing Industrial Production are Not Concerns – TMT, in general, is not tied to energy markets. If anything, falling oil prices are a net positive for companies where data center electricity use has been a growing piece of cloud computing expenses. As for industrial output, the secondary impact on enterprise IT technology demand should be modest. Moreover, as we will address, cloud solutions are inherently LOWER cost, favoring our portfolio companies in difficult times.
- FX Headwinds are Nothing New – The US dollar has risen more than 25% against major currencies from its peak in early 2014, generating major FX overhead on both sales and earnings for many of the companies in our model portfolio during 2015. A further move in the dollar caused by Fed interest rate hikes and risk from global economic weakness could extend this burden. However, for generally high margin and strong cash flow businesses, the impact is easily absorbed, as it was during 2015, particularly when the biggest risk is from the Chinese Yuan. Finally, the long standing conditions have prompted many to take advantage of hedging strategies that should blunt the impact.
- The Cloud is Deflationary – Most of the companies in our model portfolio offer cost savings to their customers. E-commerce (AMZN), digital advertising (GOOGL, FB, TWTR), streaming media (NFLX, AMZN, GOOGL), IaaS hosting (AMZN, MSFT, GOOGL), SaaS applications (MSFT, ADBE, WDAY, DATA), low cost wireless data (TMUS), turnkey reference designs (QCOM), and barebones disk drives (STX) all compete with alternatives on the basis of significantly lower all-in costs vs. alternatives. In that context, global recession, while by definition yielding declining economic activity, might hasten transition to these cloud-based solutions, making the companies that sell them counterintuitive havens.
- History Agrees with Us – Through the 2008 financial crisis and the resulting recession, the top Internet companies performed very well relative to the rest of the economy. AAPL, GOOGL, AMZN and NFLX all grew revenues at a better than 20% CAGR and earnings at better than 25% annually from 2007 to 2010, while the S&P500 saw sales down 3.9%/yr and EPS up 3.9%. MSFT – sales and EPS up 6.6% and 14.5% per year respectively – led more convention tech names in also beating the overall economy. These stocks all proved to be excellent investments as well, every one handily beating the 11.7% CAGR of the 2008-2010 S&P 500 recovery.
- Risks – Of our model portfolio, DIS and QCOM stand out as carrying the most risk from the current economic environment. In addition to Chinese and FX exposure, DIS’s sales primarily come from discretionary consumer spending, obviously at risk in a recession scenario. We have been holding DIS, as we believe that its tent pole franchises (Star Wars, Marvel, Pixar, Princesses, etc.) are undervalued, but negative economic scenarios and the clear threat to its linear TV franchises raises clear questions for 2016. QCOM has already suffered for its Chinese exposure, as it remains significantly underpaid for its IPR by many indigenous manufacturers in the wake of the now resolved dispute with anti-trust regulators. We believe a very negative scenario is already priced in for QCOM and see more upside potential than further downside risk.
- Our Shorts – Amongst the constituents of our short model portfolio, PCLN and SABR, both dependent on consumer travel, would be challenged by a recession induced slump in discretionary spending. Likewise, we believe that traditional IT vendors, like ORCL, CSCO, JNPR, EQIX, and IM would see rising pressure from cloud alternatives in a recessionary environment. Finally, component vendors – AVGO and ARW – are highly dependent on Chinese manufacturers. Chinese currency devaluation and weak global device demand could weigh heavily.
Stop Worrying About Tech
The top TMT stocks are down hard in the first two weeks of 2016. Of the 15 stocks in our long model portfolio, just three, Adobe, Nokia, and T-Mobile, have outperformed the S&P500. Of the rest, Microsoft has been roughly in line with the broader market, and Qualcomm and Alphabet have been less than 50bp behind. The remaining 11 stocks have performed poorly, likely reflecting a concern that high multiple, high beta names represent higher risk in light of the threat of global recession. (Exhibit 1)
We are not so sure. The catalysts for this market down turn have been signs of weakness in the Chinese economy, the collapse of oil prices, general weakness in industrial indicators, the strong dollar (and potential Chinese devaluation), and the resulting threat of global recession – with the contribution of the European refugee crisis thrown in. For very few companies is this a good scenario. Still, relative to the broader economy, the growth oriented names in our recommended portfolio appear relatively protected.
Exh 1: The SSR TMT LONG Model Portfolio
Few of the names on our list have significant Chinese exposure. Amazon, Alphabet, Facebook, Netflix and Twitter face government censorship and obstruction, with strong and politically favored indigenous competitors (Exhibit 2-3). As such, none of them captures substantial revenue or profit from the Chinese market. T-Mobile is entirely US based and Crown Castle nearly so. Workday, and Tableau each do roughly 20% of the overall business outside of the US – it is likely that most of that is in Europe and Japan, with very low penetration into China. Adobe may be slightly more exposed, but it is unlikely to be much higher than the 2% exposure on average for the S&P 500.
Exh 2: SSR TMT LONGs China Exposure
Exh 3: SSR TMT SHORTs China Exposure
Qualcomm has the highest exposure, at more than half of its sales, as the majority of the world’s smartphones are made in China. An economic crisis would be a serious burden as the company works to collect back royalties owed by Chinese OEMs that withheld payment pending a resolution of a government anti-trust investigation. Chip revenues are also at risk, particularly from a currency devaluation, but the end demand for devices is global rather than purely regional. The same is true for Seagate, which derives nearly half of its revenues from Asian customers. We believe the majority of that comes from Chinese OEMs, which integrate Seagate disk drives into end products aimed at world markets. This business is already in secular decline, and its weakness is fully discounted into the Seagate share price. The same PC story is also well embedded into expectations for Microsoft, which likely still gets 8-10% of its revenues from PCs made in China.
About 8% of Nokia’s 2015 revenues came from China, mainly via a $1B contract with China Mobile for 4G wireless equipment. This deal reaches completion in early 2016, and consensus expectations already include a sharp drop in Chinese revenues thereafter. Disney gets about 7.5% of its annual revenues from Asia. We believe China may be as much as 5%, as the company continues construction on its second multi-billion dollar theme park in the country. More than the other exposed stocks in our portfolio, Disney would be badly hit by a disruption in Chinese consumer spending.
Oil, Industrial Activity and FX
TMT stocks are fairly far removed from oil prices and the names in our model portfolio are not tied to broader industrial activity. The strong dollar has been an ongoing problem, with many of our constituents reporting major FX headwinds throughout 2015, as the dollar lost some 25% vs. foreign currencies. Despite those headwinds, most of the internationally exposed growth stocks delivered upside sales growth for the year. In that sense, 2016 may be more of the same, with management looking to hedge in the FX market. Component suppliers Qualcomm and Seagate have the most exposure, but Alphabet, Facebook and Microsoft all derive more than half their sales from outside of the US.
Deflationary Business Models
Most of the companies in our model portfolio compete from a position of lower prices vs. alternatives. Much of this derives from the inherent cost advantages and scale economies of cloud-based business models. For example, we estimate that the costs for world-class web-scale cloud data centers are as much as 90% lower than those for privately operated enterprise data centers. Even allowing for 20-25% operating margins, Amazon’s AWS and Microsoft’s Azure have captured more than half the emerging market for public cloud hosting, and are growing sales at 80% and 100% respectively (Exhibit 3). We believe that a recessionary environment could push some enterprises toward lower cost SaaS and IaaS solutions, with the resulting share gains vs. traditional solutions offsetting the effects of a slower economy.
The same logic is true for Amazon in online shopping, for Alphabet, Facebook and Twitter in digital advertising, for Netflix and Google for streaming video, and for Microsoft, Adobe, Workday and Tableau in SaaS application software. T-Mobile is using the combination of low prices, changing consumer buying criteria, and customer friendly policies to harvest market share from the much more expansive and inflexible market leaders. This pitch will certainly remain potent in 2016.
Exh 3: Indexed Revenue Growth, AWS versus Traditional IT 1Q14-3Q15
It’s Worked Before
In the aftermath of the 2008 financial crisis, high multiple TMT stocks performed very well. From 2007 to 2010, Google and Netflix each averaged 21% top-line growth, Amazon better than 32% and Apple better than 42%. Over the same time frame, the S&P 500 companies’ sales declined at a 3.9% annual pace, with most tech stocks faring considerably better (Exhibit 4). Microsoft grew nearly 4% per year over that time, while Hewlett Packard and Cisco each turned in 1.5% growth on average. The TMT stocks also delivered leverage to the bottom line, with Google turning in 26.5% annual EPS growth, Amazon and Facebook about 34%, and Apple, 52%.
As for stock performance, the S&P 500 rallied 39% from the end of 2008 to the end of 2010, but Microsoft was up 50%, Google was up 93%, Amazon was up 251%, Apple was up 278% and Netflix was up 488% (Exhibit 5).
Exh 4: Select TMT Sales and Earnings Metrics, 2007-10
Exh 5: Select TMT Price Performance, 2007-10
We remain confident in our model portfolio selections in the midst of the current market turmoil. Of the 15 constituents, we have called out Google, Microsoft and Twitter as our top picks for 1H16 and reiterate those selections. We would also particularly recommend Workday, Tableau, Amazon, and Netflix in light of their sizeable sell-offs. In contrast, the prospect of a broader, Chinese-led economic downturn raises additional concerns for Disney and Qualcomm.
We are also comfortable with our 15 stock short model portfolio. The stocks on this list – which we believe all have clear risks that are not reflected in their expectations and valuations – are much more exposed than our long selections. We recently called out Oracle, Juniper and Interpublic Group as our three top shorts for 1H16. In the wake of the market downturn, we would flag Avago and Arrow as at risk from China and from weakening global device sales.
©2016, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein. The views and other information provided are subject to change without notice. This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.