Quick Thoughts: Move Along Citizens, Nothing to See Here

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SEE LAST PAGE OF THIS REPORT Paul Sagawa / Artur Pylak

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August 24, 2015

Quick Thoughts: Move Along Citizens, Nothing to See Here

The traffic back from the Hamptons may have set a record Monday morning as the Dow opened down a shocking 1000 points on general squeamishiness catalyzed by another sharp drop in Chinese stocks overnight. TMT stocks, seen as risky with their high multiples and high betas, have taken a beating over the past week, capped by the Monday rout. NFLX, hailed as a conquering hero on its 2Q earnings and environment, is off 12.3% vs. last week. AMZN, crushing it in both bellwether retails sales and in its recently broken out AWS business, is down 11.2%. GOOG is off10.3% despite solid numbers and a shareholder friendly restructuring announcement. MSFT may have seen its cloud revenues up 98% in 2Q, but its stock has declined 10.1%. AAPL? Down 9.3%.

With the strong performance of the TMT leaders prior to this recent slide and with the loft valuations accorded in private financings for companies like Uber and Snapchat, there has been chatter amongst pundits and value focused investors of a new tech bubble, a perspective that may have stoked the relatively strong downdraft amongst the tech stocks. Having been followed the networking sector through their rise and calamitous fall at the turn of the millennium, we don’t see it this time. Most of the highflyers brought to earth during this recent shock are robust businesses with long visibility to years of growth and to growing profitability. Indeed, we believe that some of these businesses could prove significantly MORE resilient to a global recession than the broader market.

The cloud reduces costs. Companies like AMZN and NFLX reduce costs for consumers relative to traditional alternatives. We would expect cord cutting to accelerate in a recession, with NFLX’s $8.99 monthly fee an obvious bargain in the face of the typical cable bill. Likewise, AMZN’s efficiency has earned it a widespread reputation for low prices, helping to fuel its huge share gains at the expense of traditional merchants. These share gains would likely multiply with a more difficult economic landscape. In advertising, the 2008 economic crisis coincided with the implosion in newspaper ad sales – perhaps, tough times spurring ad buyers to shift to more cost effective digital alternatives. A new downturn could spur a similar shift from TV, a benefit to GOOG, FB and TWTR. The same is true in enterprise IT. The ’91 recession was a catalyst for shift to client-server architecture in the data center. This time, public cloud data center architecture, at a scale, is yielding a 90% cost advantage for IaaS providers – specifically AMZN, MSFT and GOOG – over client server. SaaS applications too, like those supplied by MSFT, CRM, WDAY, DATA and others, offer significant operating savings over packaged software solutions. Further pressure to reduce IT spending would be an enormous boon to these companies. Meanwhile, TMUS is winning by wooing subscribers with lower prices and more consumer friendly policies. We would expect the strategy to be even more successful in a recession.

Many TMT leaders have modest China exposure. OK, AAPL gets 25% of its sales and more of its recent growth from China. QCOM needs to collect back royalties from an army of 2nd tier Chinese smartphone makers, and like ARMH, is counting on Chinese device demand to continue apace. DIS is building a new theme park in China and its movies have done spectacularly well there. Still, most US internet based businesses are fighting a continuing battle for access to the Chinese market. This disadvantage becomes a virtue for NFLX, GOOG, FB, AMZN, TWTR and others, if a Chinese economic downturn can hamper BABA, BIDU, and Tencent in their international ambitions.

Tech leaders were much more robust than the broader market in 2008-10. During the 2008-1010 economic crisis, high-multiple tech leaders like AMZN, GOOG, NFLX, AAPL, and EBAY crushed the S&P500 on sales growth, earnings growth and share price appreciation. Microsoft, still in the midst of its lost decade, also outperformed the broader market on sales, earnings and share price. Save for the 2001 recession, which was CAUSED by the collapse of overvalued and highly indebted internet and networking stocks, high growth tech stocks have weathered bad economic times better than the rest of the market.

Valuations modest given opportunities created by paradigm shifts. The valuations for current TMT leaders are far, far below the heady multiples carried by the best loved stocks 15 years ago. Moreover, today’s cash rich balance sheets, consistent revenue growth trajectories and substantial economies of scale make the collapses like those that daisy-chained across the TMT landscape in 2001-2004 very, very unlikely. The top TMT names today are targeting huge markets – personal devices, retail commerce, media and advertising, data center IT, etc – and will likely challenge new markets on the same scale – transportation, financial services, health care, etc..

We see significant opportunities amongst the TMT stocks that have been oversold in this recent downturn. Top on our list would be NFLX, FB, GOOG, AMZN, TWTR, TMUS, and MSFT, all of which boast strong sales trajectories with obvious drivers of future growth that appear relatively recession resistant. If the indicators for Chinese consumer spending unambiguously turn down, the biggest risks amongst the larger market caps in TMT would be AAPL, DIS and QCOM.

Exh 1: TMT Sales Growth Versus S&P 500, 2007-10

Exh 2: TMT Returns Versus S&P 500, 2008-10

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