Quick Thoughts: Last Week this Morning – No Rest for TMT Investors

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

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March 2, 2020

Quick Thoughts: Last Week this Morning – No Rest for TMT Investors

  • Turmoil over the corona virus and unexpected management changes made for an extra crazy week. DIS and CRM both dropped on unexplained CEO changes, with DIS under extra pressure for its pandemic exposure. NTNX got hammered despite a nice quarterly beat on a ham-fisted guide down partly blamed on the virus. SQ flat out beat and raised guidance, taking it up against a BAD tape. Overall, software and internet names are holding up better than hardware, companies with business in China and anything related to travel. This seems reasonable.
  • DIS veteran Bob Chapek is the new CEO, with Bob Iger giving up day-to-day control to map out content strategy from the Chairman’s office. This came as a shock, given previous comments that suggested retirement in 2021 or later. With 2020 looking very difficult with the corona virus, deteriorating networks viewership, and tough compares, we believe Iger decided to go out on top.
  • CRM co-CEO Keith Block also stepped down, with Marc Benioff taking back full responsibility. Block came to CRM from ORCL in 2012 after criticisms of that company’s CEO Mark Hurd and his aggressive acquisition strategy surfaced. At CRM, Block had the title of CEO but not the power, as founder Benioff maintained a strong hand in day-to-day operations, and a conflict similar to the one at ORCL may have been in play.
  • CRM earnings were good, beating on both top and bottom lines and offering sales guidance above consensus. (EPS guidance was just in-line) Still, the numbers were a bit hard to interpret, as recent acquisition DATA was consolidated, muddying YoY comparisons. The reaction to Block’s departure and corona virus selling saw CRM off more than 8% last week.
  • NTNX posted a 4Q beat but spooked investors by guiding down, partly blaming COVID-19, and spurring a 25% sell-off. Management needs to do a MUCH better job of explaining its strategic shift from selling hardware and software licenses to subscriptions. Other companies (e.g. ADBE, MSFT, ADSK) have made the same change, which temporarily suppresses reported sales, but ultimately results in lower costs and more stable revenues. We are buyers here.
  • SQ handily beat 4Q expectations then raised guidance – a big winner in a tough week. The company is in a great position (Digital Payments: Revolution at the Register) and should be drawing meaningful looks from possible acquirers.
  • Corona Virus fears now overhang everything. In TMT, we see hardware – where Chinese demand and supply chain disruptions look worse than first assumed – and entertainment/travel – where constraints on consumer activities are killing demand – as the obvious risk areas. In contrast, we see internet and software stocks as relatively insulated from the possible pandemic.

The biggest news of the week was Disney CEO and industry icon Bob Iger announcing his immediate departure from the CEO job. This came as a big surprise, as Iger had recently re-upped his contract and seemed certain to stay for at least another year. Arguably, Iger is the most successful media executive in decades, leading Disney to dominance in movies and building and levering its formidable intellectual property franchises to support its businesses in consumer products, TV, and experiences. As such, this move shook investors who had relied on the company as a steady winner in the media space. Iger’s replacement, Disney parks head Bob Chapek is a well-regarded company veteran with experience across many lines of business. While many analysts and reporters may have expected Disney streaming honcho Kevin Mayer, given his high profile in the company’s most visible new initiative, he has been a bit of a divisive figure within the organization, particularly compared to Chapek.

The mystery remains – why now? Iger gave no clues to this a month ago around a triumphant quarter, and if the rationale was to leave on top, that would have been a logical time to do it. On the interview circuit, Iger has suggested that he had lost enthusiasm for running the day to day operations. If true, the loss was almost certainly exacerbated by the growing threats of the corona virus contagion. Disney was already facing very tough compares – no Avengers: Endgame or Star Wars this year – and the ongoing deterioration of its linear TV networks, so the virus-related hit to movie box office, parks attendance and cruise ship bookings could have been the last straw. So now Iger is free to plot content strategy from the Chairman’s office, while Chapek navigates the tough waters. We are confident that the company will emerge from the other side of this in great position, but investors may not enjoy the ride through the rapids.

Within minutes of Iger’s announcement, Salesforce co-CEO Keith Block joined the resignation party. Block had been at Salesforce since 2012, coming from Oracle where he had run North American sales. That shift 8 years ago came after messages critical of then Oracle CEO Mark Hurd and his acquisition strategy (Block was very much against the deal for Sun Microsystems) surfaced, leaving his position in the organization untenable. He had seemed happy at Salesforce, coexisting with founder and co-CEO Mark Benioff, but everyone always knew where the real power rested, and it would not be surprising to learn that there had been interpersonal conflict behind his resignation. While Block was thought as an extraordinarily talented executive and the force behind CRM’s sales prowess, the change doesn’t likely mean much for the company’s performance going forward. Benioff will continue to call the strategic shots and Salesforce has a deep bench on the sales management side.

Still, amidst the market turmoil, investors reacted badly to change despite a strong quarterly report and raised guidance for 2020. CRM was down about 8% on the week. We see this as a buying opportunity – the 20% organic growth is nothing to sneeze about, expenses are under control and the co-CEO structure was not likely to be stable anyway. While our model portfolio is stacked with other SaaS names that we think have a bit more juice, Salesforce would be a strong consideration if we opened the list to more than 15 stocks, particularly given this pull back.

One of our model constituents, Nutanix, had a horrific week, losing about a third of its value in three days despite delivering a nice 4Q beat. The problem was guidance, exacerbated by management’s frustrating inability to succinctly explain the implications of its ongoing shift from selling 3rd party hardware pre-loaded with its own software under license to a pure subscription model. Dropping the zero-margin hardware component is preferred by customers, who deploy it on their own servers, and better for long term earnings, although the immediate impact is a sharp drop in the total revenue realized from each sale. Similarly, subscriptions spread revenue over the course of the contract as opposed to collecting a license fee upfront. Thus, in the middle of this radical transformation of the revenue model, sales are artificially suppressed, with much revenue deferred over the life of the contract. This is why reported sales are up a paltry 3% or so YoY when new contract signings, a measure of the business growth of the company are up more like 40%. The light is at the end of the tunnel and as the percentage of new business under subscription nears 100% and as we get past the tough compares, Nutanix will show sharp acceleration. We expect the company to begin delivery serious upside surprises in the second half and the depressed share price will likely have suiters kicking the tires on acquisition – there are a LOT of companies that would like to slot Nutanix’s tech into their hybrid cloud story. We’d be buyers.

Meanwhile, Square crushed 4Q versus consensus expectations, growing sales 46% YoY, excluding the impact of its divestiture of the food delivery app Caviar, and topping the high end of its earnings guidance by 10%. Other metrics – gross payment volumes, share of volume from large merchants, growth from the Cash App, etc. – were uniformly strong and forward guidance was well above consensus expectations. Square shares jumped 13% the next day, before settling out at a 9% gain by the end of the week. Friday brought another interesting wrinkle for Square investors, as Elliot Management revealed a “sizeable” stake in Twitter, where Square CEO Jack Dorsey also serves as CEO, splitting his time between the two companies. Elliot has nominated 4 new board members and explicitly aims to replace Dorsey at the top of Twitter. This could prove a distraction for Square, as he fights the activist investor targeting his other job. We are very bullish on Square’s position as the retail point-of-sale metamorphosizes (Digital Payments: Revolution at the Register) and on its initiatives attacking the promising P2P payments space (Cash App) and on-line payments. We also believe it to be a tempting acquisition target for merchant banking incumbents.

Finally, all of this is playing out against the ominous backdrop of the corona virus contagion. The rapidly spreading disease has already badly disrupted Chinese consumer demand and manufacturing, seriously effecting consumer electronics (smartphones, PCs, etc.), entertainment (movies, theme parks, etc.) and travel services. We are concerned that these impacts might be farther reaching than the market reaction would suggest, potentially creating product shortages and pushing out major development cycles. A bigger threat is the potential that the Chinese situation might replay in European and North American markets. Here we are optimistic that better preparation combined with superior public health standards and infrastructure will forestall worst-case projections. Given these circumstances, we see cloud software, internet services, and generally, US-focused companies as relatively safe arenas to invest. This has played out thus far – our cloud heavy model portfolio has outperformed the S&P500 by almost 1400bp and the tech components of that index by nearly 700bp YTD (Exhibit 1).

Exh 1: SSR TMT 15 Stock Model Portfolio Performance – QTD

 

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