Small Cap TMT: Time to Stop Feeding the Bear

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SEE LAST PAGE OF THIS REPORT Paul Sagawa / Artur Pylak

FOR IMPORTANT DISCLOSURES 203.901.1633 /.1634

sagawa@ / pylak@sector-sovereign.com

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January 8, 2013

Small Cap TMT: Time to Stop Feeding the Bear

  • Small cap investing in TMT has been a bear. Since launching our small cap model portfolio 2 years ago, the TMT components of the small cap S&P600 have underperformed the tech components of the S&P500 by 640 basis points, while our model portfolio has further underperformed the small cap benchmark by 170 bp. In comparison, our large cap model portfolio has outperformed the S&P500 TMT components by 813 bp. Our small cap investment premise, selecting stocks balanced across the subsectors most likely to exploit opportunities being created by the comprehensive paradigm shift underway in the TMT sector, has been hamstrung by several structural factors. First, we believe that tightly controlled user platforms – i.e. iOS and Android – and massive cloud computing operations have concentrated the TMT opportunity toward a handful of mega-players, thwarting the ambitions of small cap challengers. Second, the mix of small cap TMT companies is skewed toward lower growth and commoditized categories. Third, an unusual proportion of the small cap universe is now composed of declining, formerly large cap companies, consistent with our thesis of an industry sea change. Finally, dysfunction in the IPO market has kept many of the most innovative small companies private. Looking ahead, we do not expect these conditions to change. Given this, we are reducing our small cap model portfolio from 25 stocks to 15 and will no longer look to balance the selections across subsectors. .
  • Small cap TMT has broadly underperformed relative to large cap, and our model portfolio has underperformed the index. We initiated our TMT small cap model portfolio in February 2011. Since that time, the TMT components of the S&P600 index of small cap stocks has underperformed the large cap S&P500 TMT components by more than 639 bp. Our small cap model portfolio has underperformed the rest of small cap TMT by 170 bp since inception, while our large cap portfolio has outperformed large cap TMT by 813 bp since its May 2011 launch. In review, we have drawn the conclusion that the small cap TMT universe has been structurally disadvantaged by the sector sea change now playing out, and that the structure of the model portfolio – 25 small cap stocks balanced across several growth themes – is not well suited to the investment environment.
  • The once-a-generation paradigm shift underway in TNT is concentrating opportunity toward large cap change leaders. The changes that we have predicted and documented over the past three years – the rise of portable platforms, wireless networks, distributed cloud data centers and cloud-based applications – largely reward scale and architectural control, driving much of the business opportunity to the advantage the large cap companies leading innovation. In contrast, many small cap face significant market barriers and cost disadvantages.
  • The small cap universe is relatively heavy in slower growth business categories. There are 170 TMT stocks with market caps greater than $3B, with 82% rated as well positioned for growth. In contrast, only 73% of the 333 TMT stocks in the $300M to $3B cap range belong to subsectors that could be labeled as growth, with nearly half of those companies either subscale cloud service providers or makers of commodity hardware for growth end markets. The average large cap TMT stock delivered 13.9% revenue growth over the past three years while the average for small cap TMT was just 12.7%, an unusual reversal relative to longer history and in defiance of the oft-quoted law of large numbers.
  • The weak IPO market has kept successful innovators out of the public market. Part of this is a consequence of the dearth of TMT IPOs. From 2003 to 2008, 215 TMT stocks came public, compared to just 104 over the past 5 years. The financial crisis and the controversial Facebook IPO overhang the market, with well-regarded new paradigm players, like Twitter, Pinterest, Square, Craig’s List, and others, remaining private as their assumed valuations continued into the large cap range.
  • The small cap universe is unusually burdened with formerly large cap companies that have fallen from grace. Of the 333 stocks in the small cap TMT universe, 72 IPOed during the past 5 years, 166 breached the $300M lower threshold from below, and 48 dropped below the $3B upper threshold from above. The population of fallen angels is high, although not nearly so high as after the collapse of the 2000 Internet bubble, but the influence of formerly large cap stocks like AMD, FSLR or ZNGA is unlikely to reflect well on small cap growth.
  • We are reducing our small cap portfolio to 15 constituents from 25 and will no longer seek to balance the selections across subsectors. Reflecting on our small cap model portfolio, too many names are there for balance rather than for conviction. In many growth categories, such as cloud hosting or mobile device software, scale advantages make attractive small cap candidates difficult to find. In this context, we see mobile device components, differentiated cloud applications, security software, and capital equipment to have the richest opportunities for small cap companies.
  • OpenText, 3D Systems and Comvault now exceed our $3B upper threshold and Ancestry.com is now private – these stocks have been removed from the portfolio. In addition, we are removing on-line marketing firms Responsys and Constant Contact, both of which focus on advertising models that are being squeezed by mobile platforms. Glu Mobile has performed poorly in a mobile gaming business in considerable flux. EZ Chip and Volterra are smaller players selling fairly commoditized solutions for embedded networking and device power management, respectively. Neither has distinguished itself during several quarters in our portfolio. Finally, we are removing Itron, which we believe has considerable promise, but in a business – smart meters for electric utilities – that is far afield of our research focus.

If it IS broke, try to fix it

Small cap TMT investing has been very difficult over the past two years. Since SSR launched its TMT small cap model portfolio in February 2011, small caps in the sector have underperformed their large cap counterparts by 639 basis points, and the broader small cap market by 1253 basis points. Our small cap model portfolio performance has been worse, underperforming the tech components of the S&P600 small cap index by 174 basis points since inception. This poor performance has come despite an ongoing gap in traditional valuation metrics vs. large caps. If measures like P/E or price to book really mattered, TMT small caps have been cheap for several years, but regression to the mean has not been a reasonable assumption for tech investors through the years. We see several reasons for this bifurcation of the TMT universe, none of which would seem likely to change in the foreseeable future.

First, we believe that the industry sea change concentrates value toward scale players in device platforms and cloud data centers. For example, Apple and Google steer users on their platforms toward their own favored apps, and to take a cut of the revenues from 3rd party apps distributed to their users. On the infrastructure front, cloud-based distributed data centers deployed by mega-caps like Amazon, Google and Microsoft are poised to exploit huge cost and performance advantages to spur an exodus of enterprise applications to platforms built on commodity hardware and proprietary open-source based software. These trends are uniformly bad for most small caps looking to carve out opportunities of their own. This has further ramifications for investors. The small cap TMT universe has much heavier exposure to slower growth categories either not benefitting from the innovations driving the industry paradigm shifts, or worse yet, at risk of obsolescence as a result of them. Moreover, the mix also includes a disproportionate slice of formerly large cap companies that have depreciated their way back into small cap status. This is not ordinarily a good signal for investors.

Small cap TMT has also been hurt by the stagnant IPO market. Of 333 TMT companies with market caps between $300M and $3B, just 72 had IPOs in the past five years. Part of this was the generally frozen capital markets in the period just post the 2008 financial crisis, but many other IPOs have been held up in the wake of the widely criticized Facebook offering. Hot companies, such as Twitter, Pinterest, Square, Tumblr, Craig’s List, Dropbox, Datapipe, or Spotify, might have come public at small cap valuations in another era.

Given all of this, we are rethinking our approach to our small cap model portfolio. Previously, we had vetted the small cap universe for companies that were predominantly tied to the growth themes that we believe are driving the market paradigm change, selecting a list of 25 balanced across these themes. We are removing the goal balancing the portfolio across the themes, as opportunities in several arenas are dominated by large cap companies. We are also shortening the list from 25 to 15 names to allow us to select stocks for which we hold greater convictions.

3D Systems, ComVault, and OpenText are being removed, as all three companies have appreciated well above the $3B upper market cap threshold. Ancestry.com has been taken private, and must be removed. We are also dropping Responsys and Constant Contact. We are enthusiastic about the on-line advertising market, but see the opportunity increasingly dominated by companies with massive data and analytic resources, such as Google and Facebook. MKTG and CTCT are at a huge disadvantage in this regard, and also focus on formats – email and text ads – that are performing poorly. We are also removing mobile games developer Glu Mobile – this market is extremely fragmented and subject to the whims of Apple and Google. We are also removing semiconductor designers Volterra and EZ Chip – neither has been able to differentiate itself in increasingly commoditized markets. Finally, we are also removing Itron, as it addresses a tangential opportunity – smart utility meters – where we have not been able to devote significant research effort.

Go Big or Go Home

The TMT landscape has been growing ever less hospitable to small cap companies over the past three years. Since we launched our small cap TMT model portfolio, small cap stocks in the TMT universe have underperformed vs. the large cap TMT by more than 2446 basis points, despite beginning the period at a 24.5 to 26.8 P/E discount. As much as we would like to leave the blame entirely on market underperformance, our stock selections for our small cap model portfolio, initiated in February 2011, have underperformed in their own right. The small cap model portfolio is down 50 basis points since inception, having underperformed the larger TMT small cap universe by 175 basis points during that time (Exhibit 1).

Exh 1: Relative Return of SSR TMT Small Cap Model Portfolio

In contrast, our large cap model portfolio has largely outperformed, not just its small cap sibling, but the broader large cap TMT market as well. The strategies for the two portfolios have been fairly similar: screen the relevant market cap TMT stock universe for companies screening as well positioned for the opportunities being created by paradigm shifts and also relatively insulated from business areas likely to be made obsolete by those same shifts, then select companies delivering a strong combination of top-line growth and cash-flow returns. However, many of the opportunities created by the TMT tectonic plate shift have not been easily addressable by smaller companies – circumstances exacerbated by the increasing power of the mega-cap companies that control user interface platforms and operate scale-advantaged distributed cloud data processing operations.

Trippin’ Off the Power

As our overarching thesis of comprehensive TMT industry change plays out, it is increasingly obvious that the biggest companies at the center of the innovations driving the change have enormous advantages in exploiting the opportunities that have been created. For example, Google and Apple have established their Android and iOS platforms as the predominant for users to access Internet based resources from portable devices. In the previous era, users accessed the Internet via neutral browsers kept separate from the operating system platform by Microsoft’s 2001 consent decree with the US DoJ. This strict separation kept Microsoft from using its platform dominance to favor its own internet applications, and thus, allowed independent web businesses like Google Search, Yahoo Mail, Amazon e-Commerce, and Apple’s iTunes to thrive.

No such separation exists in the portable platform era. Apple’s iPhone introduced Apps as convenient shortcuts to web-based resources, a concept echoed by Google’s Android, and embraced by the users of both systems. Apps give users one-click access and customized interfaces for these resources, and are the overwhelming choice of users vs. the more traditional browsers also included on the mobile platform. This approach gives the platform owner the power to guide users toward specific Apps by including them as defaults shipped with devices, or even integrating them directly into the operating system. Typically, the apps given such favor are either internally developed solutions or provided by 3rd parties willing to pay substantial fees for the preferred placement. Even if a 3rd party app developer is not blocked by a default or integrated rival, Apple and Google still take their toll via a 30% claim on all revenue generated on their platforms. This model allows the platform owners to cherry pick the best opportunities for themselves and skim profit off of the top of all of the others. This is bad news for the small cap companies that may be hoping to build their businesses on the mobile internet.

Smaller companies face considerable headwind relative to large cap market leaders in other aspects of the changing landscape as well. Cloud-based data center operators like Google, Amazon and Microsoft have built out massive distributed processing and storage infrastructures. These operations represent the cutting edge in IT technology, with massive cost and performance advantages over traditional enterprise data center implementations. As such, we believe that enterprises will migrate many of their own IT use to these cloud-based operators. Because these businesses are exploiting significant scale advantages, this growth opportunity is not well suited to small competitors. Moreover, the leaders in this market are utilizing low-cost commodity hardware and internally developed software, reducing future opportunities for smaller companies seeking to sell innovative value-added IT solutions to the enterprise market. Similar scale economies abound in the emerging TMT landscape, from wireless broadband operators to content delivery networks, and from e-commerce to streaming media.

Exh 2: Screen Summary by Subsector and Cap

Slow and Steady? Depends on the Race.

These conditions have made finding small cap companies well positioned to exploit new paradigm growth opportunities a difficult task. Sorting both large and small cap companies into 10 separate growth categories, along with a catch-all “non-growth” bucket reveals a very different mix across the cap ranges. 27% of small cap TMT stocks rate as “non-growth” vs. just 18% of large caps. Moreover, the most attractive growth categories – e.g. platforms, portable device technology, software as a service and cloud hosting – are dramatically underrepresented amongst the small caps, while commodity hardware for growth end markets and subscale cloud services companies are overrepresented. The average large cap TMT stock has grown sales 13.95% over the past 4 quarters, while the average small cap TMT stock has delivered just 12.7% growth. We note that this has traditionally broken the other way, with small caps outgrowing large caps (Exhibit 2).

A factor in this has been a steady stream of formerly large caps dropping into the small cap range. 5 of today’s small cap TMT stocks have fallen below the $3B over the past year, while just 22 large cap stocks have graduated up from small cap status. These deteriorating names are an unusual burden on a small cap universe already under stocked with strong growers.

Private and Happy That Way

The past 5 years have seen a dearth of TMT IPOs, and many of those that have come to market have waited to come out as large caps. Just 72 of the companies in the small cap TMT universe had initial offerings since 2008, with 104 total TMT IPOs over the past 5 years, compared with 215 for the previous 5 years (Exhibit 3). Of course, the financial crisis shut down new financing in all sectors for several quarters, but the widely criticized Facebook IPO in 2012 seems to have dampened the enthusiasm for TMT offerings specifically. In another era, companies like Twitter, Pinterest, Square, Tumblr, Craig’s List, Dropbox, Datapipe, or Spotify, would have already come public, with many still sporting sub-$3B market caps. Today, many have decided to wait, or in some cases, not to come public at all. With most of the best opportunities for small cap companies coming in business categories that are not particularly capital intensive, these companies can raise enough money privately and generate sufficient cash flow returns to resist the temptation to cash out in the public market.

Exh 3: Summary of IPO Activity Within the SSR TMT Screen

WhatchaGonna Do When They Come For You…

Recognizing that our approach to our small cap model portfolio has been flawed, we are changing our selection methodology. Previously, we had strived to select 25 stocks well distributed across the growth categories that we had identified through our research (Exhibit 4). However, this approach failed to acknowledge the scale disadvantages faced by smaller companies in several of those categories. As such, we will no longer look to balance the selections, and rather, will select the most attractive candidates regardless of category. Moreover, the relative difficulty in finding details on the competitive positioning of smaller companies makes maintaining the list at 25 constituents impractical. We are reducing the size of the model portfolio to 15 constituents, the same size as our large cap model portfolio and a more manageable numbers.

Exh 4: SSR Small Cap TMT Model Portfolio Performance Original Constituents Before Revision

Exh 5: SSR Small Cap TMT Model Portfolio After Removal of 10 Constituents

For this quarter, we will simply reduce the portfolio by 10 without adding new stocks. Four stocks are easy choices – OpenText (OTEX), 3D Systems (DDD), and Comvault (CVLT) have all appreciated beyond our $3B upper threshold, and are now candidates for the large cap portfolio, and Ancestory.com (ACOM) has been taken private. Two other stocks, Responsys (MKTG), and Constant Contact (CTCT) have been long time laggards and while they are on-line advertising companies, they play in elements of that market – email and text ads – that are in decline. Glu Mobile (GLUU) is a portable platform game publisher without a real tent-pole hit amongst its products. Glu’s performance has been poor and risks do not seem to justify the potential reward. Volterra (VLTR) and EZ Chip (EZCH) have been in the portfolio since inception without distinction – both offer commoditized semiconductor solutions to communications equipment manufacturers, potentially an attractive market, but both have struggled to deliver growth. Finally, Itron (ITRI) is an interesting company with a strong position in “smart” meters for electric utilities, but growth has been more sluggish than expected and the opportunity is far afield from our primary areas of research focus (Exhibit 5).

Appendix: Small Cap Screen Results

Source: Capital IQ, SSR Analysis

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